Threats or Promises? A Built‐In Mechanism of Gradual Reciprocal Trade Liberalization

21 Pages Posted: 24 May 2012

Date Written: June 2012

Abstract

We analyze an infinitely repeated tariff‐setting game played by two large countries with alternating moves. We focus on the subgame perfect equilibria in which each country chooses its tariff according to a stationary function of the other country's tariff. We show that there are many equilibria with two steady states, one with higher tariffs (but still lower than the static Nash tariffs), the other with lower tariffs. We also show that there is a special class of equilibria in which there exists a unique, globally stable steady state. In both types of equilibria, one country unilaterally reduces its tariff from the static Nash equilibrium, the other country reciprocates in response to the first country's implicit “promise” to lower its tariff even further, and this process continues forever, converging to a steady state with tariffs lower than the static Nash tariffs. Therefore, promises, rather than threats, induce countries to gradually reduce their tariffs.

JEL Classification: C73, F13

Suggested Citation

Furusawa, Taiji and Kamihigashi, Takashi, Threats or Promises? A Built‐In Mechanism of Gradual Reciprocal Trade Liberalization (June 2012). Japanese Economic Review, Vol. 63, Issue 2, pp. 259-279, 2012. Available at SSRN: https://ssrn.com/abstract=2065653 or http://dx.doi.org/10.1111/j.1468-5876.2012.00567.x

Takashi Kamihigashi

SUNY at Stony Brook ( email )

Department of Economics
Stony Brook, NY 11794
United States
516-632-7548 (Phone)
516-632-7516 (Fax)

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