Understanding US-China Trade Negotiations: The Ultimatum Game

Trade negotiations between the U.S. and China stalled last month, leaving investors with little insight on when to expect a potential trade resolution. DataTrek Research co-founder Nicholas Colas recently discussed the impact cultural differences between the U.S. and China may have on the negotiation process.

Ultimatum Game

Colas broke down the statistics of negotiation by referencing two large-scale Ultimatum Game studies.

In the Ultimatum Game, two study participants walk into a room and compete in a coin toss for a $100 prize. Once the winner is declared, the two participants are told that the winner must offer the loser a portion of his or her winnings.

If the loser accepts the offer, both sides get to keep their portion of the split. If the loser rejects the offer, neither side gets to keep any money.

Theoretically, the winner should offer the loser $1 and the loser should accept the offer, since $1 is better than zero. 

In practice, American winners offer an average of about $39 of their $100, while elite American government negotiators offer $43. At the same time, elite negotiators also expect higher offers, accepting an average deal of $31 versus $25 for the average American.

A study of Chinese negotiators found winners tend to make more accommodating offers in the $46 to $54 range compared to the $39 to $43 range offered by Americans. Yet they are also much more likely to reject lower offers, typically accepting offers in the $35 to $43 range compared to the $25 to $31 range accepted by Americans.

In other words, at least based on the numbers from these studies, Chinese negotiators tend to be more generous than Americans in their offers when negotiating from a position of strength. And they also tend to be more spiteful than Americans in rejecting the offers of others when they are at a disadvantage.

“The bottom line here is that while this is just one study, the numbers show a marked cultural difference between Chinese and American participants,” Colas wrote.

“Markets may seem volatile just now, but given the unpredictability of human nature when engaged in high-stakes negotiations, we think we’ve gotten off pretty cheaply so far.”

Other Experts Weigh In

The Sevens Report’s Tom Essaye said this week that the trade war is one of several key uncertainties creating volatility in the market.

A major divide seems to exist between market expectations for three Federal Reserve interest rate cuts in 2019 and the relatively benign recent commentary from the Fed itself, he said. 

“And that divergence is a growing, yet underappreciated risk to markets right now,” Essaye said, adding that there seems to be “absolutely zero material progress on U.S.-China trade.”

LPL Financial Chief Investment Strategist John Lynch said Tuesday that reports that the U.S. and China are back at the negotiating table are good for investors, but it may take more economic pain to get a deal done.

“We suspect that more economic pain will be inflicted on both countries, which ultimately will push the process forward. That pain, we believe, will eventually result in a trade agreement —hopefully by the end of the summer — but that is hardly assured." 

The U.S. stock market certainly seems to be holding up better than Chinese equities over the past year, although U.S. stock gains have been far from impressive.

In the past year the iShares FTSE/Xinhua China 25 Index FXI is down 14 percent, while the SPDR S&P 500 ETF SPY is up 3.9 percent overall.

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President Donald Trump and Chinese President Xi Jinping at the G20 summit on July 8, 2017. White House Photo by Shealah Craighead.