Economics 101: The Game Theory Behind Today's Trade War

The morning's headlines read like an economics exam. Tariffs. Retaliation. Stalled negotiations. If you're a fan of game theory - or an NYU Wagner MPA student - you'll recognize it immediately: the U.S. - China trade war has become a live-action simulation of the classic Prisoner's Dilemma, where every "strategic" move pushes both players toward a worse outcome.

Through the lens of Game Theory, what appears to be a high-stakes trade battle is, in fact, a predictable sequence of dominant strategies in a repeated game - one where mutual trust has broken down, and Tit-for-Tat retaliation has replaced cooperation. Unless a credible commitment mechanism is introduced, both nations - and the global economy - lose.

Dominant Strategy and the Prisoner's Dilemma: In a single-round Prisoner's Dilemma, each player has a dominant strategy: act in their own self-interest, even if mutual cooperation would lead to a better joint outcome. That's what we're seeing now: the U.S. raises tariffs to 145%, and China counters with a 125% hike. Each move is rational on its own - yet collectively destructive. It's textbook behavior from dominant strategies. We saw this coming in class.

Repeated Games and Tit-for-Tat: In repeated games, Tit-for-Tat strategies can foster long-term cooperation - if players believe the game will continue and that collaboration will be reciprocated. Once upon a time, this trade relationship held that potential. Now? Trust has collapsed. China's declaration that further escalation is "a joke" signals exasperation - and a possible refusal to play. We're teetering from an iterated game to a final showdown.

Real World Costs - Inefficiency and Escalation: The Nash Equilibrium (think of John Nash, subject of “A Beautiful Mind”) here - mutual retaliation - is stable but inefficient. U.S. farmers and manufacturers are losing export markets. Chinese consumers face rising costs. The service sector - including education and tourism - is bracing for impact. And yet, the cycle continues because, without communication, enforcement, or shared incentives, there's no reason for either side to back down.

To be sure, some argue that tariffs are necessary leverage tools to rebalance unfair trade or protect domestic industries. Indeed, Auburn Manufacturing (Maine) and MP Materials (Nevada) have benefited from tariff-driven reshoring efforts. Retailers like Walmart, TJ Maxx, and Ross Stores have adapted, leveraging supplier relationships and flexible sourcing to maintain profits. But game theory reminds us in repeated strategic interactions, short-term wins often sow the seeds of long-term inefficiencies. As both sides adopt predictable retaliation strategies, escalation becomes the equilibrium. Not because it's optimal - but because no one wants to blink. In this standoff, global markets and everyday consumers bear the cost.

This isn't just international economics. It's a behavioral strategy in motion. And right now, the two largest economies in the world are locked in a game-theoretic spiral. It's time for leaders to rewrite the rules - through credible commitments, cooperative frameworks, and trusted enforcement mechanisms. Until then, the tit-for-tat strategy we studied in class won't just live in our textbooks. It'll continue unfolding – painfully - in the real world.