(a) Assume that there are only two firms in an industry – a home firm and a foreign firm – and that the firms are competing in third-country markets. (You can have them competing in each other’s domestic markets if you wish.) Explain a “reaction function diagram” for the two firms, including the definition of a “reaction function” in this context and a brief discussion of why the reaction functions slope as they do (although you do not need to derive the functions formally). Then use a reaction function diagram (possibly along with other diagrams) to explain how a “strategic trade policy” action by the home firm’s government can potentially enhance the home firm’s market share in third-country markets.
(b) Briefly explain, in a two-country setting, how tariff reaction functions of the two governments can be constructed. Then, in a broader context, briefly indicate why this type of “game” can lead to a need for multilateral trade negotiations (such as those sponsored by GATT/WTO).