Tariffs and imperfect international

competition

Game Theory

By Eranga Kavirathna

1
 Two Stage Game
 Dynamic game with lots of players and imperfect
information.

 Imperfect information
 A player may not know exactly Who has made
What choices when he has an opportunity to
make a choice.

2
 There are more players in this Game.
 Each country has a
1. government,
2. a firm, and
3. consumers for a firm’s output. (consumers are treated
as passive in this game)

 So there are 4 players,

1. Two governments
2. Two firms

 The players change in the second stage of the game.

3
 Two governments, 1 and 2, simultaneously
choose their tariff rates, denoted by t1, t2.

 Firm 1 from country 1 and firm 2 from country

2 produce a homogeneous product for both
home consumption and export.

4
 After observing the tariff rates chosen by the two
countries, firm 1 and 2 simultaneously chooses
quantities for home consumption and for export,
denoted by (h1, e1) and (h2, e2), respectively.
 Market price in two countries Pi(Qi)=a–Qi, for i=1, 2.
 Q1=h1+e2, Q2=h2+e1.
 Both firms have a constant marginal cost c.
 Each firm pays tariff on export to the other country.

5
How high of a tariff should each
government impose?
It depend on,

 Firms behavior (Profit maximization)

 Objective of government policy (Total

welfare, Maximize TAX revenue, Maximize Home firm revenue
or Max. Consumer Surplus)

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Tariffs and imperfect international
competition

Firm 1's play for its profit:

 1 (t1 , t 2 , h1 , e1 , h2 , e2 )  [a  (h1  e2 )]h1  [a  (e1  h2 )]e1  c(h1  e1 )  t 2 e1

Firm 2's play for its profit:

 2 (t1 , t 2 , h1 , e1 , h2 , e2 )  [a  (h2  e1 )]h2  [ a  (e2  h1 )]e2  c( h2  e2 )  t1e2

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Tariffs and imperfect international
competition
Country 1's Gov. play for its total welfare: sum of the consumers'
surplus enjoyed by the consumers of country 1, firm 1's profit and
the tariff revenue
1
W1 (t1 , t 2 , h1 , e1 , h2 , e2 )  Q12   1 (t1 , t 2 , h1 , e1 , h2 , e2 )  t1e2
2
where Q1  h1  e2 .
Country 2's Gov. play for its total welfare: sum of the consumers'
surplus enjoyed by the consumers of country 2, firm 2's profit and
the tariff revenue
1
W2 (t1 , t 2 , h1 , e1 , h2 , e2 )  Q22   2 (t1 , t 2 , h1 , e1 , h2 , e2 )  t 2 e1
2
where Q2  h2  e1 .

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Backward induction:
subgame between the two firms
Here we will find the Nash equilibrium of the subgame between
the two firms for any given pair of (t1 , t 2 ) .
Firm 1 maximizes (first derivation)
 1 (t1 , t 2 , h1 , e1 , h2 , e2 )  [a  ( h1  e2 )]h1  [a  (e1  h2 )]e1  c(h1  e1 )  t 2 e1
1
a  2h1  e2  c  0  h1  (a  e2  c)
FOC: 2
1
a  2e1  h2  c  t 2  0  e1  ( a  h2  c  t 2 )
2
Firm 2 maximizes (first derivation)
 2 (t1 , t 2 , h1 , e1 , h2 , e2 )  [ a  ( h2  e1 )]h2  [a  (e2  h1 )]e2  c(h2  e2 )  t1e2
1
a  2h2  e1  c  0  h2  (a  e1  c)
FOC: 2
1
a  2e2  h1  c  t1  0  e2  ( a  h1  c  t1 )
2

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 Backward induction: whole game
Both countries know that two firms' best response for any pair (t1 , t 2 )
Country 1 maximizes ( Q1  h1  e2 )
1
W1 (t1 , t 2 , h1 , e1 , h2 , e2 )  Q12   1 (t1 , t 2 , h1 , e1 , h2 , e2 )  t1e2
2
Plugging what we got into country 1's objective function
1 2 1 1 2 1 1
( 2( a  c)  t1 ) 2  ( a  (a  c)  t1 )  ( a  c  t1 )  ( a  ( a  c )  t 2 )  (a  c  2t 2 )
18 3 3 3 3 3 3
2 1 1 1
 c ( ( a  c)  (t1  2t 2 ))  t 2  ( a  c  2t 2 )  t1  ( a  c  2t1 )
3 3 3 3
FOC:
1
t1  (a  c)
3
1
By symmetry, we also get t 2  (a  c)
3

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Backward induction:
subgame between the two firms
Here we will find the Nash equilibrium of the subgame between the
two firms for any given pair of (t1 , t 2 ) .
Given (t1 , t 2 ) , a Nash equilibrium ( (h1* , e1* ), (h2* , e2* ) ) of the subgame
should satisfy these equations.
1 1
h1  ( a  e2  c ) h2  ( a  e1  c)
2 2
1 1
e1  (a  h2  c  t 2 ) e2  ( a  h1  c  t1 )
2 2
Solving these equations gives us
1 1
h1*  (a  c  t1 ) e1*  ( a  c  2t 2 )
3 3
1 1
h2*  (a  c  t 2 ) e2*  ( a  c  2t1 )
3 3

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Tariffs and imperfect international
competition
The subgame-perfect Nash equilibrium

  1   1 
 1 1  1 h  (a  c  t1 )   2h  (a  c  t 2 )  
 t1*  (a  c), t 2*  (a  c),  3 ,  3 
 3 3 1
 e  (a  c  2t 2 )  1
 e  ( a  c  2t1 )  
  1 3   2 3 

The subgame-perfect outcome

  * 4   * 4 
 1 1  h1  (a  c)   h2  (a  c)  
 t1*  (a  c), t 2*  (a  c),  9 ,  9 
 3 3 1
 e*  (a  c)  1
 e*  (a  c)  
1 2
  9   9 

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