There is a pervasive misunderstanding of President Trump’s tariff plans. In economics, this falls under the rubric of game theory, specifically games with few players (countries), imperfect competition, and imperfect information. In this case, the players are countries. While there are 265 countries in the world,[1] only 38 are members of the Organization for Economic Cooperation and Development (OECD).[2] That’s a small number, small enough so each can keep track of the others’ strategies, actions, and policies. That means bilateral actions are not only possible, but likely. President Trump’s threats fall under the game theory topic of threat analysis.
A threat is any statement that threatens an action with negative consequences for the target country. The usual process is to make a threat to induce a change in the target country’s behavior. But we have to be careful to distinguish a credible threat from the much larger number of threats.
A credible threat is one that persuades the target country to change their behavior. If the threat is not credible, there are two possibilities:
- The target country does not believe the threatening country will follow through and take the threatened action, or
- The target country has evaluated the threat and determines that the cost imposed by the threat is less than the benefits from continuing the behavior in question.
If the target country decides the threat is not credible, they will not change their behavior. In that case, the threatening country must take the threatened action. This is the only way to maintain credibility.
President Trump has threatened massive tariffs on Mexico and Canada for a variety of reasons. Fentanyl flowing into the US is one such problem. Another is Pres. Trump’s unfounded fear of balance of trade deficits.[3] Suppose Mexico says, “Screw you. We’re not going to solve problems you created when you opened the border.” In that case, Pres. Trump must impose the tariff. And both countries’ economies will be worse off as a result. Mexico will see the quantity of exports to the U.S. fall. And U.S. consumers will pay higher prices and purchase smaller quantities for products produced in Mexico.[4]
This is the crux of the problem. Pres. Trump’s tariff policy so far has been little more than threats, with the occasional tariff imposed for a week or two. But that probably will not last forever. Threats only work if they are credible. And the only way to make them credible is to be willing and able to follow through on them.
A Little Game Theory
Games of threats are best modeled in tree format. Here’s a version of what I described above.
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Let’s start at the left side. Pres. Trump faces a choice: threaten tariffs or don’t threaten tariffs. If he doesn’t make the threat, the game is over and the payoffs to each country are zero.[5] (The payoffs are (YU and YM, the percentage change in real GDP per capita in each country.)
If he threatens tariffs, Mexico must respond to the threat. If it decides to change its behavior, the payoff to the U.S. is zero. Mexico obviously believed it was benefiting from the behavior, so its payoff is -1 (a 1% reduction in real GDP per capita).
On the other hand, if Mexico does not change behavior, Pres. Trump is faced with a decision. If he does not impose tariffs, the payoff to each country is zero.[6] And he no longer has a credible threat.
If he imposes tariffs, both countries are worse off. Mexico’s exports to the U.S. will be reduced. But U.S. consumers and businesses will face higher prices. The payoffs are -3 to the US and -2 to Mexico.
Basic game theory analysis says there is no way rational actors will ever have tariffs imposed. But the need to maintain a credible threat may outweigh the negative impacts on the economy. There are two opportunities to avoid a loss to either country. Deciding not to impose tariffs is one, but that destroys credibility. The most rational choice is to not threaten tariffs in the first place.
Why Tariffs Raise Prices
This is the most basic model of international trade. The U.S. and Mexico engage in a very large volume of trade. From the U.S. State Department:[7]
Mexico was the United States’ top goods trading partner in 2023 with total two-way goods trade at $807 billion, surpassing China. In comparison, U.S. goods trade with Canada totaled $782 billion, while trade with China totaled $576 billion. Our countries rely on closely integrated supply chains to power our economies and strengthen our global competitiveness. U.S. exports supported an estimated 1.1 million jobs in 2019 (latest data available).
U.S. merchandise exports to Mexico increased from $42 billion in 1993 (the year before NAFTA’s entry into force) to $322 billion in 2023. In 2023, Mexico remained the second-largest source of foreign crude oil to the United States, as well as the top destination for U.S. petroleum product exports and U.S. natural gas. Other major U.S. exports to Mexico include motor vehicle parts, semiconductors and other electronic components, basic chemicals, and computer equipment. U.S. Department of Commerce data shows that the United States holds the largest stock of foreign direct investment (FDI) in Mexico, with a total of $144.5 billion in 2023 (latest year available). Mexican FDI in the United States stood at $38.3 billion in 2023, according to the Bureau of Economic Analysis (BEA).
Mexico exports crude oil to the U.S. From the Energy Information Administration (EIA):
In 2023, the United States imported more crude oil from Mexico and paid less per barrel than in 2022. U.S. crude oil imports from Mexico averaged 733,000 barrels per day (b/d), 15% more than in 2022. Global crude oil prices declined in 2023, with the Brent crude oil spot price averaging $82.41 per barrel (b) compared with $100.94/b in 2022. Despite the increased import volumes, the lower crude oil prices reduced the value of U.S. crude oil imports from Mexico by 4% in 2023 compared with 2022. U.S. crude oil imports made up 81% of all energy imports from Mexico in 2023. The United States did not export any crude oil to Mexico in 2023.
As always, click here to download my Excel workbook.
Let’s use the 2023 average price, $82.41 per barrel. Suppose the U.S. imposes a tariff of $15 per barrel. Here’s the equilibrium before the tariff.[8]
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And here’s the equilibrium after the tariff:
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The new equilibrium price is $9.78044 above the original equilibrium. That is $5.2204 less than the $15 tariff. The tariff shifts the supply curve vertically by the same amount, $15. But the demand curve slopes downward. Part of the impact of the higher price is lower quantity demanded. That quantity reduction accounts for the $5.2204 difference.
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Do Tariffs Cause Inflation?
In the long run, inflation can only be caused by excessive increases in the quantity of money in circulation. But in the short run, there can be many factors that cause the average price level to rise. As we learned during the OPEC oil disruptions of the 1970s, an increase in the price of oil flows through many sectors of the economy. We think of transportation. But solvents, plastics, artificial fibers, and many chemicals start out as oil. Where does the asphalt that paves roads come from? Partly oil.
So an increase in the price of oil will cause an increase in the overall price level because of the impact on so many different sectors. If people and businesses think the price level increase is an indicator of inflation beginning, they will adjust their behavior to reflect these new expectations. Those adjustments will cause further increases in the price level.
It’s starting to look a lot like inflation, but what about the money supply? The central bank faces a difficult dilemma. They can accommodate the inflation by increasing the money supply. That will, inevitably, lead to higher inflation. Or they can fight the inflation by holding the money supply constant. That is likely to lead to a temporary slowdown in economic activity, possibly even a recession.
Nobody ever said being a central banker was fun.
- CIA World Factbook, https://www.cia.gov/the-world-factbook/. Accessed December 1, 2024. ↑
- https://www.oecd.org/en/about/members-partners.html Accessed January 4, 2025. ↑
- Technically, the deficit is the in the current account. Basic international income accounting tells us that a c current account deficit must be matched by a financial account inflow. One example would have been Nippon Steel’s offer to invest $2 billion in U.S. Steel. That would have been a really big inflow! ↑
- If you’re skeptical about tariffs leading to higher prices, read on. ↑
- The payoffs are zero because each country is no better or worse off than it was before the potential threat. ↑
- Remember, payoffs are only in real GDP per capita. Impacts on the participants’ egos or reputations are not counted. ↑
- https://www.state.gov/u-s-relations-with-mexico/#:~:text=Mexico%20was%20the%20United%20States,of%20Economic%20Analysis%20(BEA). Accessed January 4, 2025. ↑
- I assumed the price elasticity of demand at the current equilibrium is -0.2. This is consistent with numerous studies. And, yes, I realize there are many flaws in my model. Its main purpose is educational, not analytical. ↑
