Trade wars and trade disputes: The role of equity and political support

Abstract

Recent theoretical and quantitative analysis of trade wars is grounded in a relatively narrow treatment of optimal tariff theory and noncooperative Nash equilibria. The lynchpin of this approach is the assumption that trade policy makers are rational and have a simple well‐established objective function to optimize. We argue that the preferred specification of this objective function ignores inequality at its peril. We work with a quantitative trade model, introducing a comprehensive tariff‐space grid search new to the literature. This allows us to explicitly check for the presence of multiple Nash outcomes. We show that including income inequality—a primary focus of the earlier literature—as a determinant of social welfare can substantially change noncooperative Nash outcomes. We also show that the optimal tariff of the US falls by half when the social welfare function includes inequality as an objective. Hence, the economic outcomes of actual trade wars may be very different from what recent estimates grounded in optimal tariff theory would suggest.