Consider trade relations between Australia and New Zealand. Assume that the leaders of the two countries believe the pay-offs to alternative trade policies are as follows: Australia Low tariffs, New Zealand​​ Low tariffs = Australia gains $10 billion, New Zealand gains $10 billion​​ Australia High tariffs, New Zealand​​ Low tariffs = Australia gains $20 billion, New Zealand gains $2 billion Australia Low tariffs, New Zealand​​ High tariffs = Australia gains $2 billion​​, New Zealand gains $20 billion Australia High tariffs, New Zealand​​ High tariffs = Australia gains $4 billion​​, New Zealand gains $4 billion a) What is the dominant strategy for Australia? For New Zealand? Explain. b) Define Nash equilibrium. What is the Nash equilibrium for trade policy? c) Under the Closer Economic Relations agreement, Australia and New Zealand both agreed to allow free trade in goods and services between the two countries. Do the perceived pay-offs as shown here justify this move to a bilateral free trade policy? d) Based on your understanding of the gains from trade (discussed in Chapters 3 and 9), do you think that these pay-offs actually reflect a nation's welfare under the four possible outcomes?

a) The dominant strategy for a player is the action that yields the highest payoff regardless of what the other player does. For Australia, the dominant strategy is to impose high tariffs, as it gains more ($20 billion vs$10 billion when New Zealand has low tariffs, and $4 billion vs$2 billion when New Zealand has high tariffs). For New Zealand, the dominant strategy is also to impose high tariffs for the same reason.

b) A Nash equilibrium is a set of strategies, one for each player, such that no player has incentive to unilaterally change her action given the other player’s action. In this case, the Nash equilibrium is for both Australia and New Zealand to impose high tariffs. This is because, given that one country is imposing high tariffs, the other country always does better by also imposing high tariffs.

c) The pay-offs as shown here do not justify a move to a bilateral free trade policy. Both countries would gain more by imposing high tariffs. However, this analysis ignores the potential long-term benefits of free trade, such as increased competition, innovation, and efficiency.

d) These pay-offs may not fully reflect a nation's welfare under the four possible outcomes. The gains from trade include not only the direct benefits of increased exports and reduced imports, but also the indirect benefits of increased competition, innovation, and efficiency. These indirect benefits are not captured in the pay-off matrix. Furthermore, the pay-off matrix does not take into account the distribution of gains within each country. For example, while the country as a whole may gain from high tariffs, certain groups within the country (such as consumers) may be worse off.