A Tariff Model with Bilateral Deterrence

This paper develops a dynamic real-options model of tariff deterrence in which the exporting country, though subject to the importing country’s market power, assumes the role of leader in a Stackelberg framework under uncertainty by acting preventively to dissuade the importer from imposing a tariff. The follower holds an option to impose a tariff subject to irreversible enforcement costs, while the leader can undertake costly deterrence, through signaling and capacity building, to delay or prevent action. The interaction generates a preventive equilibrium in which the importing country (the follower) optimally remains inactive, and the exporting country (the leader) sustains continuous deterrence expenditures, which nevertheless may be preferable to submit to tariffs. Uncertainty and irreversibility, which can both be manipulated, enlarge the inaction zone, and increase resilience and adaptability of both contenders. Both conditions tend to stabilize the system but transfer costs asymmetrically: the powerful waits costlessly, the weaker pays to maintain stability. In equilibrium, deterrence requires continuous spending by the leader to keep the follower indifferent between acting and waiting, implying that power operates through potentiality rather than action. The paper extends the Stackelberg framework to international trade, revealing that although the theoretical first-mover advantage rests with the larger, importing country, the smaller, exporting country becomes the de facto leader by acting preemptively to discourage the threat of tariff.