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/ THE GAME THEORY OF BREXIT

The Game Theory of Brexit

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"Applying a game theory approach is actually quite insightful since it provides a logical way of picking through the
various claims and counter-claims of those in favour of and against leaving"

Wednesday, 15 March 2017 9:38 AM

0
By Neil McCulloch

The most important question in British politics right now is: Will we get a good deal at the end of Article
50? Leavers argue that Europe needs us more than we need them and that a good deal is therefore
likely. Remainers point to strong incentives for the EU to 'punish' the UK in order to send a signal to
other would be exiters. Who is right?

As an economist, the question cries out for the use of one of the standard tools of the trade – game
theory. Game theory is the branch of economics invented by John Nash, the Nobel prize winner
featured in the film The Beautiful Mind. Nash was the first to formalise mathematically a way of
determining the likely outcomes when two or more parties are playing a game and each has various
strategies that it can deploy and different valuations for the various outcomes that might arise.

Whether or not it works, applying a game theory approach is actually quite insightful since it provides a
logical way of picking through the various claims and counter-claims of those in favour of and against
leaving.

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Consider a game with two players: the UK and the EU. For simplicity, let's say that the EU has just two
possible strategies it can pursue. It can give the UK a good deal, or it can give the UK a bad deal. Given
this, the UK also has two strategies. It can either accept the deal it finally negotiates, or it can reject it
and exit the EU with no deal.

The reality is obviously more complex than this simple framework. The EU can offer lots of options
between good and bad and the UK is involved in the negotiations so can help to shape what is on
offer. But this simple framework can still reveal some important insights.

Now let's put some valuations on the possible outcomes from the EU and the UK playing all the
possible combinations of these strategies. Figure 1 shows one possible set of values.

Figure 1: Outcomes in the Brexit game

The numbers in brackets in each cell indicate the benefit for each player given the strategies adopted.
The first number in each cell is the outcome for the UK; the second is the outcome for the EU (the
reason for the question marks are explained below). The numbers chosen are illustrative. They don't
correspond to an actual estimate of gains or losses – all that matters is their relative size.

Take the top right cell where the EU offer a good deal and the UK accepts it. This gives an outcome of,
say, minus 2 for the UK. I've chosen -2 simply to reflect the fact that pretty much any realistic deal with
the EU is unlikely to give the same full access to the single market as the UK currently has, but under a
good deal I assume that loss isn't too bad. If you are a Leaver and believe that the EU will give a deal
that is better than our current access, you can make the numbers positive if you like – none of the
results I will show depend on the absolute numbers I've chosen.

Now consider the top left cell. Obviously, if the UK accepts a bad deal it will be worse off than under a
good deal. I've arbitrarily said that the payoff for the UK under this situation is -8. Now compare this
with the payoff in which the UK drops out of the EU with no deal. This is clearly very bad for the UK, so
I've given that -10. So far the strategy for the UK is clear: accept whatever deal is on offer, unless the
EU offers something worse than -10, in which case the UK would walk away.
Now consider the game from the EU's perspective. The EU has two competing incentives. From an
economic perspective, it would like to give the UK as good a deal as possible, since a good deal for
the UK will be better economically for the EU too. On the other hand, it may wish to punish the UK for
leaving in order to dissuade future leavers. The tension between these two factors is illustrated in
Figure 2.

Figure 2: The political and economic costs of a Brexit deal for the EU

Figure 2a: Economic and political costs exactly counterbalance

Figure 2b: Economic and political costs result in an optimum position for the EU
Figure 2a shows that a Brexit deal that is bad for the UK (-10 quality on the horizontal axis) would be
good politically for the EU (the blue line) – but also terrible economically for the EU (the orange line).
Conversely a Brexit deal that is good for the UK (0 quality) would also be economically good for the
EU, but terrible politically.

If the two effects are exactly equal and opposite to one another, then the overall economic and
political outcome for the EU would be the same (-5) regardless of the quality of the final deal for the
UK. The economics and the politics cancel each other out.

If this is the case, then the Leavers are right. The EU will basically be indifferent between a good and a
bad deal for the UK because of the competing economic and political costs for themselves, so all the
UK needs to do is to offer some additional small inducement to the EU and the rational response for
the EU will be to go along with a good deal. After all, they are going to get -5 regardless of what
happens, so they might as well give the UK -2 instead of -8, if the UK can do something to help
improve the -5 somewhat.

Before Leavers get excited, this outcome is critically dependent on the assumption that the economic
and political costs exactly counterbalance one another. If the economic costs to the EU of giving the
UK a bad deal outweighed the political costs of giving the UK a good deal, then the EU would offer the
UK a good deal. This is what the Leave campaign have always argued would happen.
Conversely, if the political costs of giving the UK a good deal outweighed the economic ones, then the
EU would give the UK a bad deal. And Britain, as long as it was better than crashing out with no deal,
would accept it. This is what many Remainers have often argued.

In reality, there is likely to be an optimum deal from the EU perspective. Consider Figure 2b. The
situation is the same, but the curves are no longer straight. This means that the EU would be very keen
to avoid a terrible deal for the UK which would also harm them, but the additional economic benefits
of a good deal reduce as the deal gets better. Conversely, the additional political cost of giving the UK
a good deal also rises as the deal gets better. Intuitively, this is a more likely scenario.

However, if we now look at the average political and economic cost to the EU, we see that there is a
clear optimal quality of deal – not too bad, so that the EU economy is harmed, but not so good that it
would encourage other member states to leave.

Now looking back at Figure 1, we can see that, as long as the optimal deal for the EU is better than -10,
then the UK will accept that deal. In other words, the equilibrium is that the EU will offer the UK a
mediocre deal – and the UK will accept it. This strikes me as a much more plausible outcome. The deal
will not be as good as the Leavers claim but neither will it be the Armageddon that Remainers have
warned about.

Note however that the UK has no control at all in this game. The outcome is determined entirely by the
balance of political and economic costs in the EU. As long as the deal is not worse than crashing out, it
is rational for the UK to accept it.

Now let's add a wildcard into the mix. Barrister Jolyon Maugham
(http://www.prospectmagazine.co.uk/magazine/brexit-take-back-contr) and a number of others are
attempting to get the Irish courts to refer the question of whether triggering Article 50 is irrevocable to
the European Court of Justice (ECJ). If they are successful, the ECJ will decide whether the UK could, if
it wanted, decide that the best alternative to a bad deal would be to stay in the EU rather than to crash
out without a deal. If it turns out that the UK has this right, how might this change the negotiating
dynamic?

Figure 3 shows the same information as Figure 1, but with an additional strategy for the UK of staying in
the EU.

Figure 3: Outcomes of Brexit game with the option to stay

What scorings should be put for the UK and the EU for the option to Stay? Remainers would argue that
this is the status quo and hence the payoffs should be (0,0). But there is a significant political cost for
the UK government associated with changing its mind and staying. I've therefore chosen a value of -8.
This choice is significant because it is less bad than the cost of dropping out of the EU without a deal.
In effect, I am assuming that, while the majority of the UK would be happy with a good or even a
mediocre deal, they might prefer staying in the EU to crashing out with no deal.

Now consider the payoffs to the EU as a result of the UK staying. If the EU offered a good deal, but the
UK decided instead to stay in the EU, then the situation would revert to the status quo and the payoff
for the EU would be zero. However, now consider the situation in which the EU offers a very bad deal
(I've chosen -15, but anything worse than -10 will do). Given this, the UK's best option is to stay in the
EU. It only gets -8 doing this, whereas all of the other options are worse. This would be humiliating for
the UK, but it would also be a political win for the EU so I have scored the payoff for the EU above zero
at 5 (again the number doesn't matter as long as it is above zero).

Now consider the equilibrium of this new situation and, in particular, the impact of the UK having the
option to stay. The answer is not good for the UK. If the UK has the legal right to stay, and the EU is
better off if it does so, then the optimal strategy for the EU is to offer a truly terrible deal. It no longer
makes sense for it to offer its own preferred equilibrium of -5 as before. Now it will offer something
worse than -10. Why? Because if it offers a deal that is so bad that the UK could not possibly accept it,
then the UK will be forced to choose between crashing out without a deal and the status quo. If (and it
is an important if) the shame of changing its mind is less bad than a hard Brexit, the equilibrium of this
game is the bottom left hand corner in which the UK stays in the EU.

This is why Maugham and his co-claimants strategy is both very clever and also very risky. It moves
the equilibrium from one in which the EU provides a mediocre deal which the UK then accepts, to one
where the UK is forced to choose between two extremely uncomfortable options – one which is
economically disastrous and another which would be politically disastrous, at least for the current
government. In short: Game on.
Dr. Neil McCulloch is an Oxford-based economist focusing on developing countries. He was previously
the director of the Economic Policy Program at Oxford Policy Management and the lead economist of
the Australian Aid program in Indonesia. He also led the Globalisation Research Team in the Institute of
Development Studies in the UK and was a senior economist for the World Bank in Indonesia.

The opinions in politics.co.uk's Comment and Analysis section are those of the author and are no
reflection of the views of the website or its owners.

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