Gaming Tariffs: Finding logic in economic stupidity

Writer: Hardik Srivastava

Editor: Krithi Kankanala

If one were to identify the necessary and sufficient conditions for globalisation, the first that probably comes to one’s mind is trade. In many ways, trade is one of the most basic truths of economics: scarcity requires the transfer of goods from one place or person to another, and which is trade. The very nature of globalised trade makes it a prime target for politicisation.

This politicisation can manifest in  several ways, but the most popular, and some would argue, most effective way of politicising international trade is through tariffs.

What are Tariffs?

A tariff is essentially a tax imposed by a government on imported goods. When Country A places a 10% tariff on steel imports from Country B, any company importing that steel must pay an additional 10% to Country A's government on top of the purchase price. While governments often justify tariffs as tools to protect domestic industries, generate revenue, or respond to unfair trade practices, they fundamentally make imported goods more expensive for domestic consumers and businesses. This price increase is designed to make locally-produced alternatives more competitive, even if they're less efficient to produce.

Understanding Game Theory

Game theory is a framework for analyzing situations where the outcome of your decision depends not just on what you choose, but on what others choose as well. Think of it like a chess match: your best move depends entirely on anticipating your opponent's response. In game theory, we map out these strategic interactions using payoff matrices—simple tables that show what happens under different combinations of choices. Each "player" (whether a person,

Understanding the Payoff Matrix

	Country A: Cooperate (No Tariffs)	Country A: Defect (Tariffs)
Country B: Cooperate	(0, 0)	(-x, -y)
Country B: Defect	(-y, -x)	(-x-z, -y-z)

This table shows the economic outcomes for both countries under different scenarios. The company, or country) is assumed to act rationally in pursuit of their own interests. The key insight is that what's rational for each individual player often leads to outcomes that are worse for everyone collectively. This tension between individual rationality and collective welfare is exactly what makes game theory so powerful for understanding international trade disputes.

The ideal libertarian economic state has 0 tariffs across its basket of goods. While this sounds obvious, there's several reasons to explain why tariffs make no sense in the ideal world, with  the most comprehensive way of thinking about this being  game theory.

Applying Game Theory in Trade

When we apply the game theory framework to international trade, what emerges is a classic prisoner's dilemma played out across national borders. In order to comprehend how tariffs can be represented in game theory, consider an example: imagine a world with only two trading partners, Country A and Country B. Each faces a binary choice: cooperate by maintaining low tariffs, or defect by raising them.

In an ideal world where both countries cooperate and maintain zero tariffs, both achieve the best possible outcome for everyone collectively. Trade flows freely, and each country can focus on producing goods where they have a comparative advantage. This means they can produce certain goods more efficiently (or at lower cost) relative to other goods they might produce. For instance, if Country A can produce wine more efficiently than cloth, while Country B excels at producing cloth over wine, both benefit when they specialize and trade. Consumers in both nations enjoy lower prices and greater variety. This is what economists call a Pareto-optimal outcome: a situation where you cannot make anyone better off without making someone else worse off. It's the theoretical sweet spot where no improvements are possible without trade-offs.

Any deviation from this ideal creates what economists call deadweight loss. This refers to economic value that simply disappears rather than being transferred from one party to another. Imagine a transaction that would have made both a buyer and seller better off, but doesn't happen because a tariff made it too expensive. The potential benefit to both parties just vanishes; nobody captures it. It's pure waste, like friction in a machine converting useful energy into useless heat.

numbers represent losses relative to the ideal free-trade baseline (0, 0), where both countries cooperate. Here's what each scenario means:

●      (0, 0): Both cooperate with no tariffs. This is our baseline, the best collective outcome.

●      (-x, -y): Country B cooperates, but Country A imposes tariffs. Country A suffers a loss of x (tariffs hurt their own consumers and disrupt supply chains), while Country B suffers a smaller loss of y (they face barriers to Country A's market but still have open markets themselves).

●      (-y, -x): The reverse situation where Country A cooperates while Country B defects. Now Country A suffers the smaller loss y, and Country B suffers the larger loss x.

●      (-x-z, -y-z): Both countries impose tariffs in a trade war. The losses compound: both countries suffer their original losses (x and y) plus additional damage (z) from the multiplicative effects of mutual retaliation. Supply chains break down, prices spike, and inefficiencies cascade through both economies.

The key insight is that x > y in most scenarios: the country imposing tariffs typically hurts itself more than it hurts its trading partner, because tariffs are essentially taxes on your own consumers and businesses.

The Temptation to Defect

But here's where human nature and political reality intrude upon economic theory. Each country faces a tempting unilateral deviation: what if we could maintain access to foreign markets while protecting our own domestic industries? This is "beggar-thy-neighbor" logic, the idea that you can enrich yourself by impoverishing your neighbor, like stealing their customers while they continue buying from you.

History shows how seductive this thinking can be. During the Great Depression, the United States passed the Smoot-Hawley Tariff Act of 1930, which raised tariffs on thousands of imported goods to protect American industries. Other countries retaliated with their own tariffs, and global trade collapsed by roughly 65% between 1929 and 1934. What seemed like rational self-protection for each individual country produced collective catastrophe.

The mathematical structure of the payoff matrix reveals why this thinking, while individually tempting in the short term, proves collectively disastrous. We can  approach this explanation in two ways: first, through a "this is why tariffs are economically destructive, but countries still use them" lens, and then through a "this is why tariffs are economically destructive, but everyone should do it anyway" lens that reveals the darker logic of modern trade policy.

This is why tariffs are illogical but countries still use them

The welfare losses from tariffs don't scale linearly: they follow a convex function that economists have empirically validated across numerous trade disputes . A modest 5% tariff might cause minimal distortion, but a 25% tariff doesn't just cause five times the damage; it causes something closer to twenty-five times the harm. This superlinear relationship exists because tariffs don't just transfer wealth from consumers to producers, they create cascading inefficiencies throughout the entire economic system. You've probably heard of a multiplier effect for improvement in aggregate demand. This follows the same idea, but instead of multiplying demand x times, it divides it by x .

The mathematical formulation is elegantly put:

Welfare Loss = A (Tariff Rate)²  (Import Share)

(A is a scaling coefficient that doesn’t hold much importance for us))

That squared term is doing all the heavy lifting here. When the Trump administration imposed 30% tariffs on roughly 20% of Chinese imports, the welfare destruction wasn't just 30% worse than a 10% tariff, it was nine times worse per percentage point affected . This is why economists get apoplectic about tariff policy in ways that seem disproportionate to the layperson.

But if tariffs are so economically destructive, why do rational political actors keep implementing them? The answer lies in the concentration of benefits versus the diffusion of costs. When a government imposes a 25% tariff on steel imports, the domestic steel industry experiences immediate, visible gains. Steel workers keep their jobs, steel company profits rise, and steel-producing regions see economic activity increase. These benefits are concentrated among a relatively small, well-organized constituency that has every incentive to lobby for protection.

The costs, meanwhile, are spread across every consumer and business that uses steel. Your car becomes $200 more expensive, but you don't trace that back to steel tariffs. Construction costs rise marginally, but builders absorb some costs and pass others along in ways that obscure the original cause. The aggregate welfare loss might be ten times larger than the concentrated benefit, but it's politically invisible. This is classic public choice theory: concentrated benefits triumph over diffuse costs, even when the math clearly favors the latter.

This is why tariffs are illogical but everyone should apply them

Now here's where the prisoner's dilemma reveals the downside to all this; where even the most ardent free-trader might pause. In a world where other countries impose tariffs, there is very little that is objectively worse than unilateral free trade. You're asking others to shoot you in the foot today, and not incentivising them to stop shooting tomorrow.

Consider the payoff matrix that emerges from recent empirical studies of US-China trade relations . When both countries maintain low tariffs, both achieve baseline welfare (0, 0). When the US defects unilaterally by raising tariffs while China maintains free trade, the US suffers moderate welfare loss (-25) while inflicting smaller damage on China (-10). But here's the crucial insight: when China retaliates and both countries impose tariffs, the welfare destruction becomes superlinear (-180, -25).

	China: Cooperate (No Tariffs)	China: Defect (Retaliate)
US: Cooperate	(0, 0)	(-5, -2)
US: Defect	(-25, -10)	(-180, -25)

The asymmetry in these numbers tells us something profound about the modern global economy. The United States, as a massive importer with complex supply chains, suffers disproportionately from mutual tariff escalation. China, with its export-oriented model and greater state capacity for industrial policy, can better weather the storm. This suggests that in a world of strategic tariff competition, the traditional economic logic might be backwards.

If you know your trading partner will impose tariffs regardless of your actions, then imposing retaliatory tariffs becomes not just politically necessary but economically rational. You're not choosing between free trade and protection; you're choosing between being exploited and fighting back. The welfare loss from mutual defection might be enormous, but the welfare loss from unilateral cooperation could be even worse when it invites further exploitation.