Tit-for-Tat in Trade: How Political Bias Leads to Trade Disputes

Purpose - This paper examines how unstable trade disputes arise under a Tit-for-Tat (TFT) strategy when political bias is private information. It categorizes trade states into Free Trade, Protectionist, and Trade Dispute, demonstrating how a Trade Dispute emerges under different levels of political bias and information asymmetry. Design/Methodology - The model considers two trading countries that determine trade policies. While imposing tariffs is a dominant strategy, TFT can sustain Free Trade with retaliatory threats under certain conditions. Countries may impose tariffs either to maximize surplus or as a retaliatory measure. Political bias parameters remain private information. I analyze how different trade states emerge under varying political biases and compute the resulting surplus. Findings - TFT functions when retaliation is explicitly declared and enforced. If countries develop a stronger protectionist bias, they adopt the dominant strategy of raising tariffs and enter the Protectionist State. However, when the political bias level is private information, a country may strategically impose higher tariffs under the guise of retaliation, pressuring its counterpart to lower tariffs while maintaining high tariffs itself. The initial tariff-imposing country cannot discern its counterpart’s true intent, destabilizing TFT and leading to the Trade Dispute State. Originality/value - This paper explains the rise of protectionism and trade disputes using a single TFT model. A stable Protectionist State emerges when political bias is strong, whereas an unstable Trade Dispute State arises when political bias is moderately strong and its level is private information.