The Game Theory of Tariffs: How Cooperation (or Lack Thereof) Shapes Global Trad...

Imagine you're playing a game where your choices depend on what others decide, and their choices depend on what you decide. Game theory is the study of how people make decisions in situations where everyone's choices affect each other. Simply, it's like figuring out the best strategy in a game by thinking about what others might do and how they'll react to your moves. This helps in understanding and predicting behaviors in competitive and cooperative situations, not just in games, but also in real-life scenarios like business, politics, and economics

More than ever, game theory is a great tool for businesses to deploy, because tariffs are more than just taxes—they're tools of strategy, power plays, and economic chess matches. By applying game theory to both governmental and corporate pricing behavior in tariff environments, we can gain a clearer picture of the high stakes involved and provide a sense of control and confidence in decision-making.

Government Strategy: Cooperation vs. Defection

Let’s start with an example of a simplified game theory matrix between two governments deciding whether to cooperate or defect on trade policy. They have 3 possible outcomes in which each government has 2 possible choices. They can cooperate or defect. Depending on their independent choices, the outcomes are: both cooperate, both defect (to act against the mutually beneficial option in favor of one own’s outcome), or one defects and the other cooperates. The economic outcome of each scenario can be estimated.

For the purposes of discussion, let’s use a point system to represent $. In reality, when using game theory for decision making, one must estimate the economic result of the scenario.

Here’s an example of possible outcomes of a China / US trade war.

• Cooperate-Cooperate: Both countries benefit in an increase in GDP, let’s say for the example earning 5 points each.
• Cooperate-Defect: Only one country wins, and the other loses. The defector gains 6 points, while the cooperator loses out with -1 point.
• Defect-Defect: Both countries suffer reduced gains, receiving only 2 points each.

This is an iterative game, meaning actions in one round influence the next. So one must ask after each round, because one country behaved in a certain way in round 1, is there an implied change in likelihood of their behavior in round 2.

Once one country defects, trust breaks down, and both sides begin to defect, reducing overall trade benefits. It’s a classic short-term gain leads to long-term loss.

But the implications go beyond theoretical points.

Pricing Strategy in a Tariff Economy

Game theory also applies to how companies respond to tariffs. Let’s consider two firms—Company A (a U.S. business) and Company B (its competitor). Let’s play out each scenario.

Scenario 1: Cooperation (Both companies raise prices)

• A Cooperates, B Cooperates:
  A gains 7 points by balancing profit and market share. A does not need to increase prices as much as B, and as such, steals customers while also raising prices.
  B gains 3 points, seeing moderate success.

Scenario 2: Defection (One or both companies maintain prices)

• A Defects, B Cooperates:
  A gains market share but loses 1 point due to falling profits and a shrinking consumer base interested in purchasing within their market.
  B maintains profitability despite losing some market share as their higher prices offset their losses in market share, gaining 1 point.
• A Defects, B Defects:
  Both companies struggle.
  A loses 3 points, B loses 5 points.
  B eventually leverages domestic efficiencies in their home country to stabilize losses.

The lesson? Defection may promise short-term gains, but as prices increase and consumer bases shrink, both sides lose. The market punishes those who think only tactically instead of strategically.

Companies that actually use this tool while estimating the actual financial result for themselves and their competitors under each scenario can build a strong picture of what strategies are likely to optimize results.

Final Thoughts: Pricing in a Tariff-World

In a globalized supply chain, components cross borders multiple times. Tariffs aren’t a simple linear price increase—they ripple through every layer of production. Companies must price strategically, accounting for compounding cost increases, even if they’re based in the U.S.

The smart approach is to assume tariffs are recessionary. In this market, cooperation—between governments and between firms—might just be the best path to sustainable success.