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Nash Equilibrium in US-Mexico Trade

1. Consider trade relations between the US and Mexico. Assume that leaders of the two countries believe the payoffs to alternative trade policies are as follows:

US' policy
Low Tariffs High Tariffs
Low Tariffs US gains $25b US gains $30b
Mex gains $25b Mex gains $10b
High Tariffs US gains $10b US gains $20b
Mex gains $30b Mex gains $20b
Mexico's policy

a) What is the dominant strategy for the US? For Mexico?
b) Define Nash equilibrium. What is the Nash equilibrium for trade policy?
c) In 1993, US Congress ratified the North American Free Trade Agreement (NAFTA), in which the US and Mexico agreed to reduce trade barriers simultaneously. Do the perceived payoffs shown here justify this approach to trade policy?

Solution Preview

a) See the attached file. Each country's best outcome given the other country's strategy is underlined. Each country gains more by charging a high tariff no matter what the other ...

Solution Summary

Given a payoff matrix for possible trade policies between the US and Mexico, this solution defines and finds the Nash equilibrium.

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