Tariff Game Theory in Middle Earth

Using first principles economics and Tolkien to understand tariffs

(Image credit: http://lotrproject.com)

Tariffs have dominated recent US foreign policy news. Canada has been the most publicized, but since January, the Trump administration has both threatened and levied tariffs against a host of countries, and many countries have in return levied new or increased tariffs against the US. Trade wars are nothing new; indeed, the last few decades of relatively free international trade are the historical exception rather than the norm. Today, we are going to take a step back from the details of current policy and instead build a general model of tariffs using game theory¹.

First, a quick definition: when we say “tariffs,” we specifically are talking about import tariffs. There are also export tariffs (or export duties), but they are much less common. Our discussion today (and all the recent tariff zeitgeist) is around import tariffs. An import tariff is a tax on an imported resource. As a quick example, let’s assume the US sets a 25% tariff on timber. If a Canadian company is selling wood for $100/cord, a company in the US would need to pay $100/cord to the Canadian company and then an additional $25/cord in taxes to the US government, resulting in a total cost of $125/cord. Pretty straightforward.

Back to building our model of tariffs. To do so, we’re going to use the classic economic example of key sovereign powers of Middle Earth prior to the War of the Ring²: Gondor, Rohan, Moria, Isengard, and Mordor. We are going to be taking on the role of Denethor³, steward of Gondor, and we are going to attempt to create a tariff policy that is best for our people. We’ll first look at our trading relationship with each of the other powers, and then from those scenarios we’ll draw some general strategic conclusions.

Since for the purpose of this exercise we are only interested in setting our tariff policies, we are only going to look at the resources that we import from other kingdoms and not look at our exports or overall trade balance⁴. Obviously the other kingdoms will be doing the same analysis on what they import from us.

Rohan

The first trading relationship we will examine is with Rohan, an ally of ours, though not as close as they once were. We import grain for bread and horsehair for fine clothes from them. Rohan is able to provide these goods more cheaply by virtue of fundamental advantages in these industries: Their geography and climate allow them to grow grain more abundantly, and their skill in animal husbandry allows them to produce more high-quality horsehair.

So, let’s consider, should we levy tariffs against these industries? If we do, we have two options: a tariff that increases the price of the foreign goods, but still leaves them cheaper than domestic goods, or a tariff that makes the foreign goods more expensive than domestic goods.

In the first case, we aren’t protecting our local grain and horsehair industries, since the foreign goods are still cheaper, but we are making it more expensive for the dependent industries (bakers and tailors) to purchase the resources they need for their industries. Therefore, the price of bread and clothing will increase. In and of itself, prices going up with no benefit is obviously a net negative for our kingdom.

That money didn’t disappear—the difference in the old and new prices is captured by our government. But, what are we going to do with that additional wealth except for give it back to the people in some form? And unless we think that we can spend money more wisely than our people can directly⁵, we might as well not have introduced the tariff at all and saved ourselves the trouble. All we did was artificially distort the economy to no one’s benefit⁶.

Ok, how about the second option? — A tariff large enough that the goods from Rohan are now more expensive than our domestically produced goods. Now instead of wealth going to the government, consumers will eschew paying the high tariff and instead spend money to purchase from our domestic grain and horsehair industries. These industries will grow, since now they can profitably sell their goods more cheaply than imported goods.

But is this good for our nation’s economy as a whole? Bread and clothes, by definition, will now be even more expensive than they were with the first version of the tariff. We will have “created” some domestic jobs, but the people working those jobs could be employed in some other industry that we do specialize in. We are fundamentally less efficient at producing grain and horsehair, so by introducing this tariff, we will have cut our people off from Rohan’s basic economic advantages that they were willing to export to us.

Lothlorien

So it seems a tariff on Rohan may not be the best idea. Let’s look next at Lothlorien, another somewhat aloof ally. Our records show that our only major import from them is rope. Like with Rohan’s skill with animal husbandry, the elves of Lothlorien are renowned throughout Middle Earth for their rope making skill — a basic economic advantage. We are about to dismiss this as an identical case, when our herald announces that Harandil—Gondor’s foremost rope maker—is at the door and requesting an audience.

Given that we are currently reviewing the tariffs on his industry, we allow him in.

“My Lord Denethor,” he begins. “I beg of you to consider placing a tariff on the import of this elven rope. I do not pretend to have no stake in the outcome, but not only would a tariff help me and my fellow rope makers, in due time it will also benefit all of the people of Gondor. If our local rope manufacture is allowed to grow without the influence of these foreign imports, it will reach a scale where we can produce rope of equal quality as cheaply as they! And, even failing that endeavor, it is well known that the productivity of Lothlorien is decreasing as more of their people make the journey to the Grey Shores. Soon there will be insufficient rope to import and we will be forced by necessity to expand our local production. A prescient tariff would forestall any shortage in rope production.”

”Thank you, Harandil,” we respond, “Your counsel will be taken into consideration.” With a bow, he turns and leaves.

Harandil makes some compelling points. He is certainly correct about the output of Lothlorien decreasing. Our reports show that they have steadily produced less rope over the last decade, and their population is in irreversible decline. His claim about matching their quality and price with local production is more dubious; the skill of the elves is not easily replicated. We would need a thorough understanding of rope manufacture before we could efficiently judge how likely that is to be true.

However, do we necessarily need to make that decision? If it is indeed true that expansion of the local industry will eventually be very profitable, then Harandil should be able to make his case to a local guild (bank) and secure financing for expansion of his industry. The guilds are incentivized to make profitable investments, so if a guild deems the investment is sound, then it will provide the resources for Harandil to expand. If the guilds deem that the time is not yet right and Harandil is unable to convince them, then he will have to wait until the market will provide financing for him.

By allowing the market to determine when expansion will be profitable rather than trying to stimulate it ourselves, we have saved ourselves the necessity of understanding rope making (something that we have no expertise in) and we have allowed our people to take advantage of the high-quality elven rope for as long as it is available⁷.

Moria

Ok, so once again it seems we do not need a tariff. Let’s now look at our relationship with Moria. Again examining our records, we see that from Moria we import raw metal ore and leather. The ore isn’t surprising — Moria has a basic economic advantage of abundant natural ore veins in close proximity. As we just saw with Rohan and Lothlorien, applying tariffs on a foreign industry that has a basic economic advantage just means higher prices for our people, so the same analysis applies. However, the leather is surprising. Moria does not have any particular advantage in leather production, so how are they producing it so cheaply?

We reach out to some of our contacts in Rivendell (the elves always keep an eye on the dwarves), and they tell us—horror of horrors—Moria is subsidizing the leather industry! A percentage of all mithril sales are distributed to tanners every month, allowing tanners to charge below cost prices. Surely this justifies a tariff, since this subsidization is a clear distortion of the free market. Right?

Well, again, let’s consider it from our people’s perspective. Right now, they are able to purchase leather at an “unrealistically” low price, which they are of course quite happy about. The subsidy from Moria is making us wealthier! They are taking a portion of their natural economic profits from mithril mining and using it to give us cheap leather. If we introduce a tariff to offset this subsidy, we are essentially rejecting their gift.

There is a downside, though. Our domestic tanners are going to likely be put out of business by this cheap leather. They can’t compete with these low prices. But, that is simply the nature of free market economics, if someone invented a new proprietary technology that made leather production substantially cheaper, it would also put the tanners out of business. It may seem “unfair” that they are being put out of business by foreign subsidy instead of new technology, but from an economic perspective, whether the discount comes from subsidy, technology, or some other means, the overall result is that general population gets to buy goods more cheaply. And being able to buy the same good more cheaply makes the nation of Gondor as a whole richer.

What happens when Moria stops subsidizing leather production and prices increase? The domestic leather industry will become viable again and will re-emerge. There may be a temporary period where prices increase past what they used to be domestically as the industry ramps up again, but eventually prices will return to their pre-subsidy level. We took advantage of the subsidy while it lasted, and now we are back to business as usual.

Isengard

Up until recently we have not had a trading relationship with Isengard, since we generally are distrustful of Saruman and his lust for power. However, Isengard has started exporting very cheap lumber, and naturally our local industries have started importing it. After sending some spies to discover what is going on, we discover that Saruman is using slave Uruk-hai labor to harvest and process the trees around the tower of Orthanc incredibly cheaply.

We are naturally opposed to slave labor on moral grounds, however, we have a somewhat vexing economic issue. This is another case of government subsidization of an industry, but this time via oppressive laws that allow for cheaper production of resources. In essence, Isengard is exporting the well-being of its citizens. And just like with Moria, if we levy tariffs against that export, we are preventing our people from reaping the benefits of that subsidy for as long as it lasts.

We could try to ruin Isengard’s export economy by embargoing them, but unfortunately, our enemy Mordor is willing to purchase all of the lumber that Isengard can produce. And as long as we refuse to trade with Isengard, Mordor is gaining the full “well-being” export from Isengard, which gives them a substantial economic advantage. Depending on how long Isengard is willing to export its people’s well-being and how important lumber is to Mordor’s development, we likely will reach a point where we have to choose between either declaring war on Isengard to prevent them from enriching Mordor, or accepting Isengard’s cheap lumber so Mordor no longer is the only one benefiting.

Economically, the obvious choice is to simply accept the cheap lumber. We are responsible for the well-being of our people not other kingdoms’ people, and allowing the lumber import provides more wealth for our people at no cost to us. If our policy is that which happens outside of our borders is not our concern (so long as it doesn’t threaten us), then this is the clear choice.

On the other hand, if we decide that it is too much of a compromise to profit from slave labor, that leaves us with war. War is extremely ineffective from a global economic perspective, since it is fundamentally destructive. However, it can be a viable choice for a kingdom that (a) is good at it and (b) produces the resources for it. Thankfully, we do both, so it’s something we can consider as part of our foreign policy. That also takes us to…

Mordor

Up to this point, moral questions about profiting from slavery aside, it seems that the best option in all cases is to not apply tariffs. Cutting our people off from the economic benefits of other kingdoms’ permanent natural advantages or temporary subsidies always results in less wealth for us than allowing free trade.

We now come to Mordor, our eternal enemy. In looking at our most recent trade reports, we notice something very strange—we are importing refined steel from Mordor at impossibly low prices. Cheaper even than Moria, who has a clear basic economic advantage in mining and smelting.

What’s going on here? Surely Mordor is subsidizing their steel industry, but why? And why sell to us of all kingdoms, since they know steel becomes weapons?

Here is where our consideration must extend past strictly economic principles. Like with Moria and Isengard we could take advantage of the resource Mordor is exporting and capitalize on their subsidization to enrich our kingdom. However, there is a serious long-term problem. In our discussion of Moria we mentioned that the foreign subsidy would likely put our local tanners out of business, but that they would return once Moria stopped subsidizing leather. During the time that our local tanning industry was getting restarted, there may be a shortage of leather. Not ideal, but we had an extended period of cheap leather in exchange for it.

The same is true for steel production, with one key difference: We need steel to make the weapons to defend our kingdom. What happens if Mordor declares war, stops its export of steel, and begins marching on our borders? If Grond is at the gates of Minas Tirith, we cannot repel it with swords and shields that are going to be made in 6 months. We need them now. And it certainly takes less time to march an army from Minas Morgul to Osgiliath and then to the White City than it does to restart steel manufacture.

We will have temporarily gained wealth from Mordor’s cheap steel. But unless a substantial portion of that steel went into weapons manufacture, we may soon find ourselves conquered. And then all of our wealth will be stolen.

So, it appears the prudent course of action is to apply a sufficiently large tariff to Mordor steel to keep our domestic steel production healthy. It doesn’t necessarily need to prevent all steel import, but it needs to prevent enough of it that if Mordor attempts to cripple us by halting steel exports, we will still be able to defend ourselves.

Lessons

Principles

Ok, so now that we’ve looked at the trade relationships of Middle Earth, what general principles can we draw?

1. A tariff is only useful when a resource can be purchased from a foreign power more cheaply than it can be purchased from domestic producers. This should be quite obvious: for equivalent products⁸, people will buy from whomever offers the best price. If that best price is from a domestic producer, there will be no reason to purchase from a foreign producer. If there is no reason to purchase from a foreign producer, then a tariff will have no effect. As Gondor, we didn’t worry about tariffing things we are the best at producing (such as weapons or wine), because everyone in our kingdom already had better prices buying domestically than importing.

2. There are two basic ways a foreign nation can produce a resource more cheaply than it can be produced domestically.

1. The foreign nation has a basic economic advantage in production. This can be better technology, larger scale, better access to natural resources, more effective laborers, etc.

2. The foreign nation subsidizes the industry. This can be directly via financial subsidies or indirectly via laws that improve profitability (such as laws that reduce workers’ rights or provide free access to resources on government land)

We saw case 1 with Rohan’s grain or Lothlorien’s rope, and we saw case 2 with Moria’s leather or Mordor’s steel.

3. A nation’s subsidization of an industry is, fundamentally, an export of that nation’s citizens’ well-being. In the case of Moria’s direct leather subsidies, they were using some of the wealth from mithril sales that should have gone to their people to instead give us cheap leather. In the case of Isengard they were taking away the rights of their people to provide cheap lumber.

4. On paper, a tariff is always a net negative for the country levying the tariff. We saw that with either basic economic advantages or government subsidy, the best way to maximize wealth for our people is to allow free trade. Even tariffs aimed at developing domestic industry (Harandil’s proposed rope tariff) are better replaced by financing in the open market. Otherwise the government has to evaluate the potential for each industry, a task it is not designed to do effectively.

5. Our country doesn’t exist on paper. While a no tariff policy may maximize our wealth, if we outsource industries vital to our defense, then all of the wealth we have accumulated may soon be taken from us. With Mordor, we saw that taking advantage of their cheap steel could be potentially disastrous if we came into conflict with them, even though in the short term we would be enriching ourselves at their expense.

Strategy

So let’s put together a general strategy. Based on the Mordor example, we see that if a nation doesn’t protect industries required for national defense, it puts its sovereignty at risk. We need to apply tariffs insofar as they are necessary for national defense. Should we consider adding tariffs in any of the other scenarios we looked at? What about for food production? What about clothing production? Remember, for each tariff we add, our people are losing out on the economic benefit of importing cheaper foreign goods. We could become completely isolationist and embargo all foreign trade, but then everyone else will be able to take advantage of each other’s basic economic advantages and subsidies, and we will be missing out.

To maximize wealth without risking our sovereignty, we want to apply tariffs only so far as they are necessary for national defense. Beyond that, we want to take advantage of either the basic economic advantages that other nations are willing to export, or the inherent inefficiency of other nations’ subsidization policies. I call this strategy “Greed and Guns”—take advantage of everything you can, but make sure you always can make your own guns (that includes the production of all of the raw materials necessary to make guns, not just gun manufacture itself).

The downside of this approach is that you do not necessarily produce your own food or other essentials. Consider what would happen in our Gondor scenario if Rohan suddenly decided to stop exporting grain to us. Our people will starve unless we find another source of food.

This is where the military is a unique investment. If we have a large enough military, we can use the time-honored tradition of Bigger Army Diplomacy (BAD)⁹ to threaten Rohan into a favorable trade arrangement. In theory, all we need to do is ensure we have a sufficiently strong military and we can always trade for or acquire any necessary resources. Mathematically it maximizes the wealth of the nation: We take advantage of the maximum possible foreign subsidies, and our domestic economy will develop around those prices. I’m an engineer, so Greed and Guns tends to be my preferred strategy.

But BAD tends to create enemies, so if we want to avoid that necessity, we may want to extend some tariffs to protect a minimum amount of domestic food production, creating a “Greed, Guns, and Grain” tariff policy. Or maybe a “Greed, Guns, Grain, and Gears” policy if we also want to make sure that we produce our key technologies domestically as well. For each industry we protect, we are removing our need to negotiate for that industry’s resources on foreign markets. But we also are making that resource more expensive for our people.

Conclusion

Ultimately, tariff policy is about trade offs. We can maximize profits by following a military-only tariff strategy, or we can seek maximum independence by aggressively applying tariffs to all industries at the cost of increased prices. Real-world tariffs are enormously complex, but the general principles and simplified examples presented here can hopefully provide a useful lens to view them through.

To conclude, let’s return to that real world. Up until very recently, the US has basically had just a “Greed” policy, not even “Greed and Guns”¹⁰. The current administration seems intent on changing that. How fast and how far that goes remains to be seen. But the days of completely open trade appear to be at least temporarily coming to a pause. It will necessarily come at the cost of higher domestic prices. We’re sacrificing some Greed for Guns, Grain, and Gears. Time will tell if the sacrifice pays off.

1. Game theory is “the study of mathematical models of strategic interactions.” Essentially it just means applying first principles logic to the interactions between people or nations. An Austrian economist would call this “praxeology”—the study of human action.

2. Tolkien nerds will have to accept a bit of Middle Earth political anachronism in some of the economic relationships in order to allow for trade between all the powers and to keep the example simple. My most sincere apologies.

3. In this alternate timeline Denethor has not looked into the White Tower’s Palantir and is not slowly descending into madness. If this reference doesn’t make sense to you, you need to stop reading this article and go read Lord of the Rings.

4. Also, trade balance alone is a wildly overrated national economic health measure, but that’s its own article.

5. Being a good Austrian school steward (or just by observing the incompetence of our own staff), we know this will never happen. The government is always less efficient with money than the free market. Plus, we aren’t getting the full value of the tariff as pure profit, since some of that profit must pay for the bureaucracy to collect the tariff.

6. Well, except for the bureaucrats who would potentially have cushy jobs collecting tariffs. These are the childless lords that sat in aged halls musing on heraldry, or in high, cold towers asking questions of the stars. Gandalf does not approve of them, and neither do I.

7. It is worth noting that this strategy is only possible if we have an economy advanced enough to provide long-term industrial loans. Thankfully for both Gondor and any first-world country today, this is easily the case. Banks are more than happy to extend loans on profitable projects.

8. It is worth noting that “equivalent products” is entirely defined by the purchaser. Some people may view all 2% milk the same, others may put a higher value on a particular brand or farm’s 2% milk, or they may make a distinction between American and Canadian milk, or organic and non-organic. Whenever we are referring to tariffs on the “same product” we are referring to it in terms of the perceptions of the purchaser, not necessarily a molecularly identical product. In Austrian economics, we would say products that people view as the same are a “perfect substitute” for one another.

9. Credit for the term “Bigger Army Diplomacy” goes to CGP Grey (at least that’s where I first heard it, I’m sure others have used it before, but it is one of my favorite statecraft expressions)

10. While the U.S. still directly manufactures most of its own weapons, production of the capital goods required for those weapons, particularly mining, has largely moved overseas.