The Game Theory of Tariffs: What’s Next for Markets in 2025?
Introduction
The United States has once again entered a period of heightened trade tensions, implementing new tariffs on Canada, Mexico, and China as of February 2025. These tariffs—25% on Canadian and Mexican imports and 10% on Chinese goods—are intended to address concerns over trade imbalances, immigration, and national security. However, history tells us that tariff battles often lead to economic instability, market volatility, and retaliatory measures from affected countries.
Using game theory, we can predict how key players—these trading partners and the U.S.—will likely respond, and what that means for businesses, investors, and markets in the months ahead.
Game Theory and the Likely Outcomes
At its core, this tariff standoff resembles a prisoner’s dilemma, where each country must decide whether to retaliate, negotiate, or absorb the costs. Historically, tit-for-tat strategies dominate trade disputes—when one country imposes tariffs, others respond with their own. However, escalating trade wars harm all players, making cooperative negotiation the rational long-term move.
We can analyze the possible payoffs for each country using a simplified scoring system based on economic and political outcomes:
Game Theory Matrix
Optimal Strategies Based on Payoff Outcomes:
Short-Term (0-6 months): Tit-for-Tat Retaliation Likely
Canada and Mexico implement countermeasures on U.S. exports (-2 U.S., -2 Can/Mex).
China retaliates selectively while also using WTO legal pressure (-3 U.S., -3 China).
The U.S. maintains tariffs but does not escalate immediately.
Medium-Term (6-12 months): Two Likely Paths
Trade War Escalates (-3 to -5 U.S. loss) if the U.S. raises tariffs further.
Negotiations Begin (+2 U.S.) if selective tariff exemptions are introduced.
Long-Term (12+ months): New Trade Agreement or Selective Tariff Rollbacks
U.S. rolls back some tariffs in exchange for minor trade concessions (+2 U.S., -1 China).
Markets stabilize as trade uncertainty fades.
What History Tells Us About Tariff-Induced Market Shocks
If history is any guide, market volatility is almost guaranteed. During the 2018-2019 U.S.-China trade war, tariffs wiped out an estimated $1.7 trillion in U.S. equity value, according to National Bureau of Economic Research (NBER). The S&P 500 saw multiple sharp drops following major tariff announcements, with trade-sensitive sectors—manufacturing, agriculture, and retail—taking the hardest hits.
Similar dynamics could unfold in 2025. If the U.S. maintains or escalates tariffs, markets will likely react negatively, especially in import-heavy industries like autos, semiconductors, and consumer goods. However, if the administration signals willingness to negotiate or selectively remove tariffs, stocks could stabilize as trade uncertainty diminishes.
Projected Market Scenarios for 2025
Based on historical patterns and current policy directions, three potential market trajectories emerge:
Best-Case Scenario (+10% S&P 500 growth): Partial tariff rollback, inflation stabilizes, and earnings growth remains strong. Markets rally as trade fears subside.
Moderate-Case Scenario (+3% S&P 500 growth): Tariffs remain, but minor exemptions ease supply chain disruptions. Market performance remains modest.
Worst-Case Scenario (-15% S&P 500 decline): Trade war escalates, inflation surges, and Fed policy remains tight. Stocks tumble as economic uncertainty rises.
For businesses, the next 6-12 months are critical. Importers should negotiate supplier contracts, seek alternative sources, and monitor tariff exemption opportunities. Investors should hedge exposure to trade-sensitive sectors while considering companies with strong domestic supply chains.
Conclusion: What’s the Most Likely Outcome?
While the tariff battle of 2025 is still unfolding, one thing is clear: markets hate uncertainty, and trade wars historically lead to short-term losses before negotiations eventually bring stabilization. The most probable scenario based on game theory is that tariffs will remain in place for the next 6-12 months, causing economic and market turbulence, but selective reductions and trade agreements will follow within 12-18 months.
The key takeaway for businesses and investors? Prepare for volatility, explore supply chain alternatives, and watch for diplomatic signals that could indicate a turning point in this economic chess match.
Credits
This article was developed through a collaborative effort between Landon Phillips, MBA, and ChatGPT using the Chat4o engine. This work reflects a shared exploration of economic dynamics in response to global trade policies.
Disclaimer: The information presented here is for educational and informational purposes only and should not be construed as financial advice. I am not a licensed financial advisor, and my portfolio may not align with your financial goals or risk tolerance. All investments carry risks, including the potential loss of principal. Historical data and model-based projections are not guarantees of future performance. Always consult a licensed financial professional before making any investment decisions.