Haggling over the Terms of Trade

JA Morrison | LSE
Simulation 1
2 February 2021

Want to use this material in your own course? Consult this page.

Note to Instructors: This simulation requires a carefully constructed series of tables (in spreadsheets) that are shared with students. Naturally, the production costs (and thus opportunity costs) have been crafted to drive the negotiations toward specific strategies and thus learning outcomes. These spreadsheets also include formulae that allow students to play around with various hypothetical trades.

Preliminary Remarks

I have done this kind of simulation previously but never over Zoom. I’ve made some specific adjustments, but challenges remain.

I tested this with my Maggie who hates this kind of thing; and I tested this with Hadley who likes this kind of thing but is 13 years old. In both cases, it worked well!

Your objective: maximise the economic utility you gain; bracket other concerns (for now).

There will be several rounds of negotiations in various scenarios. But the point is to illustrate underlying concepts. So, I will work you through some things as we go; and we will discuss connections to our bigger questions.

Round 0: setting your objectives and formulating your strategy

  • two groups, each given their own cost structures; but not given the cost structures of the other side.

Step 1: prepare negotiation strategies

Consult sheets 1, 2, and 3…

    1. production costs & possibilities–specifies costs and thus production possibilities and “utility.”
    1. calculator–allows you to explore the implications of different trade “deals.”
    1. schedule (no trade) – charts the production possibilities without trade.

Formulate your negotiation strategy by answering the following questions:

    1. using sheet 1, what is your cost of ale in terms of wine?
    1. using sheet 1, what is your cost of wine in terms of ale?
    1. using sheet 2, do you want to increase or decrease the number of bottles of ale traded for each bottle of wine?
    1. using sheet 2, what is the break-even point, the point at which you are indifferent?
  • Spain: what is the minumum number of bottles of ale you need to get for each bottle of wine to ensure that you are better off trading rather than not?
  • England: what is the maximum number of bottles of ale you are willing to send for each bottle of wine to ensure that you are better off trading rather than not?
    1. are you better off with more specialisation or with less?

Step 2: discuss

Learning objectives:

  • more specialisation is better rather than less; the best path is full specialisation with a good trade deal.
  • you want to “sell” your exports for the highest “price” you can, meaning get the most imports for your exports (this is what is properly called “the terms of trade”).
  • it might be difficult to know, ex ante, where your comparative advantage lies (although I will tell you, just to get us started more easily).
  • you cannot know the cost structures of the other side without experience and/or research.

Round 1: bargaining blind

Step 1: negotiate

Each side gets to make 4 offers. Perhaps a deal is reached; but, perhaps, not!

At this point, you have no information about the cost structure of your potential trading partner. Perhaps, they value 1 bottle of wine at 200 bottles of ale; or perhaps they value it at just 2 bottles of ale! In other words, you are negotiating blind. But while you cannot know (yet), you can begin to discern their position by carefully interpetting their offers.

But I will tell you two things. First, England has a comparative advantage in producing ale; and Spain has a comparative advantage in producing wine. So, we are going to assume maximum specialisation and maximum trade. Second, both countries find that 1 bottle of wine is worth at least as much (>=1) as 1 bottle of ale.

For this reason, the offers should be made using the following form:

  • England: I offer to give you x bottles of ale for your 10 bottles of wine.
  • Spain: we want to receive y bottles of ale for our 10 bottles of wine.

Step 2: reflect and discuss

Learning objectives:

  • you cannot know the cost structures of the other side without experience and/or research. This makes negotiations difficult; and you cannot know if you were offered a “good” deal!
  • but you can get some information from the negotiations themselves.

Round 2: informed bargaining

Step 1: get better information

Now you can observe the cost structures of the other side; and you have the experience of the previous round. We also move to a proper schedule, which makes it easier to scrutinise various deals and scenarios. Now, we can see the bargaining range…

Q. If Spain exports the maximum amount of wine (10 bottles), what is the minimum amount of ale they need to import to ensure that they gain from trade?

Q. The maximum amount of wine that England can purchase from Spain is 10 bottles. What is the maximum amount of ale they are willing spend to ensure they gain from this trade?

Bargaining range

Above 24 ale to 10 wine, and England walks away. Below 21 ale to 10 wine, and Spain walks away. So, for 10 wine, the bargaining range includes: 24, 23, 22, and 21. Spain wants to get as high a number of possible. England wants to drive that number as low as possible.

Step 2: negotiate

Where do we end up?

Each side gets to make 4 offers. Perhaps a deal is reached; but, perhaps, not!

Round 3: asymmetric traders

Step 1: simulate rapid economic growth

Let’s increase the production capacity of England 10-fold:

  • ale: 5 per day –> 50 per day.
  • wine 2 per day –> 20 per day.

Putting things in terms of our previous lecture and seminar, this is analogous to “hegemonic ascent.” Examples include: the UK after the napoleonic wars, the USA after World War II, and perhaps China today.

Let’s consider the same questions…

Q. if Spain exports the maximum amount of wine (10 bottles), what is the minimum amount of ale they need to import to ensure that they gain from trade?

Q. the maximum amount of wine that England can purchase from Spain is 10 bottles. what is the maximum amount of ale they are willing spend to ensure they gain from this trade?

Notice that the theory of comparative advantage still holds!! We have not changed the rate of opportunity costs: England can produce much more wine and much more ale, but the ratio is still the same (5 bottles of ale for every 2 bottles of wine). In fact, we still have the same bargaining range…

Bargaining range

Above 24 ale to 10 wine, and England walks away. Below 21 ale to 10 wine, and Spain walks away. So, for 10 wine, the bargaining range includes: 24, 23, 22, and 21. Spain wants to get as high a number of possible. England wants to drive that number as low as possible.

Q. as you consider the possible terms of trade, complete the following statement for each of the potential rates: “this historic trade deal increases our economic gain by x percent.” (where “x” is the increase in utility.) how do the statements compare, considering your upcoming reelection campaign?

You can see that one thing has changed, which might come to really matter: the percentage gain for England has gone down considerably. Dropping from 25 ales for 10 wines to 24 ales for 10 wines only brings England a gain of 0.2 percent. Previously, it brought a gain of 2.0 percent!

Step 2: negotiate

Will England hold Spain’s feet to the fire?

Step 3: discuss

Q. what is the implication of this for the negotiations?

Round 4: multi-level, multilateral trading

Step 1: simulate adding new players

We maintain the production capacity of England at its high level:

  • ale: 5 per day –> 50 per day.
  • wine 2 per day –> 20 per day.

But now we add a number of players who are smaller in size to Spain and England.

Portugal.

  • ale: 0.5 per day.
  • wine: 0.6 per day.

South Africa.

  • ale: 0.5 per day.
  • wine: 0.6 per day.

In some sense, this parallels the experience of the middle and larger powers in Europe “discovering” “colonial opportunities”–near and far. Also, I am picking countries that have traditionally exported nice wines–to make it seem a little more realistic! :)

Deducing preferences

Q. if Portugal and South Africa export the maximum amount of wine (5 bottles), what is the minimum amount of ale they need to import to ensure that they gain from trade?

Q. the maximum amount of wine that England can purchase from Portugal and South Africa (combined) is 10 bottles. what is the maximum amount of ale they are willing spend to ensure they gain from this trade?

Step 2: negotiate

How will the discussions play out?

Step 3: discuss

Q. How do the positions, and interests, of Portugal and South Africa compare to that of Spain?

Q. Are Portugal and South Africa better off sending their wine to England? or to Spain?

Q. What incentives does this create for a middle-sized power (e.g. Spain in our simulation, but also germany, USA, and japan in the 19th century)?

Conclusion

Review the terms set.

  • how did they change as actors became more experienced and better informed?
  • how did they change as the number of actors and the distribution of power changed?

Consider this terms of our 3 big course questions.

  • what is the role of material variables versus ideas–understanding, knowledge, experience, and skill?
  • what is the role of agency, and what is the role of structure? how have your views changed?
  • what is the relationship between politics and economics? is this unrealistic? in what way or ways?

Limitations of the simulation:

  • no domestic interest groups.
  • no security linkages.
  • limited expertise.
  • limited repeated play.
  • limited time and research opportunities.