UBS: Broken - Economic Insights

One of the gravest uncertainties is the UK's new-found position as a potential partner in global trade negotiations. Here, the application of game theory gives some very clear insights, all of which point to one,i nescapable conclusion.

In a momentous, and surprising, result the UK voted to take a leap into the unknown. We have moved from a binary situation where one outcome was known (remain) and the other unknown (leave). Now the UK faces multiple potential outcomes, all of which have unknown consequences. One of the biggest uncertainties is the nature of the UK's trading relationships with the EU and the rest of the world.

Trade negotiations are always complicated: there are so many vested interests and so many potential trade-offs. When faced with complexity it is always useful to simplify as much as reasonable, and then ask if the complications change the simple conclusions. And in trade negotiations the simple question is one of bargaining power, which means we can use game theory to give us the simple conclusions.

To start with, consider a negotiation between two parties with equal or similar bargaining power, such as the EU and China.To keep things simple, we assume that they both want some sort of deal; it is simply a question of how many concessions you can get from the other party. The pay offs are the same for each party since they have equal bargaining power; in other words the trade deal is equally important to both. In all four of the possible outcomes (chart 1a) the preferences are listed in order from 1 to 4, with 4 the most favourable.To solve a game like this, each player should consider whatt heir opponent will do in response to any of their moves, and choose between the available outcomes.

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