A Model of Trade Wars

The dissertation offers a theoretical model of why countries engage in trade wars. The underlying aim is to understand the current US-China trade war. Existing oligopolistic competition models explain tariffs as beggar-thy-neighbour policies. Countries have an individual interest in levying tariffs to capture some of the profits of other countries. However, when all countries do this, they are worse off than under mutual free trade. This explanation makes sense in most cases of trade barriers. However, it offers an incomplete understanding of trade between countries that pose a security threat to each other. Drawing on insights from political science, I argue that the economic surplus created by trade has potential security implications. This is because countries can use the surplus to invest in military capabilities, which they might deploy against each other in a future war. Wars between two countries can at most have one winner. Accordingly, when countries that pose a security threat to each other set tariff rates, they need to consider the security implications: how does trade impact their relative ability to invest in military capabilities? I model tariff setting when trade has security implications with a two-country duopoly. Both countries have one firm that operates in both markets, selling an undifferentiated good under Cournot quantity competition. I assume that both countries put given weights on the social welfare gains from trade and security concerns when setting tariffs. I solve the model for the Nash tariff. Two main findings follow from my model. First, the more weight countries put on security concerns, the higher the Nash tariffs become. Second, in an iterated prisoner's dilemma, more weight on security concerns decreases the set where it is possible to sustain free trade. Moreover, even when sustaining free trade is possible, the discount factor necessary to do this is higher. The model offers a plausible explanation of the outbreak of the US-China trade war. National Security Strategy documents reveal that the Trump administration saw China as a bigger security threat than previous administrations, and accordingly put more weight on security concerns. This shifted the US-China relationship from a free trade to a tariff equilibrium. My model also helps to explain why, at the time of writing, there is no end in sight to the trade war, despite the clear negative impact it has had on both sides