UC Irvine

We analyze a dynamic, two-country model that highlights the various trade-offs each country faces between current consumption and competing investments in its future productive and military capacities as it prepares for a possible conflict in the future. Our focus is on the circumstances under which the effects of current trade between the two countries on the future balance of power render trade unappealing to one of them. We find that a positive probability of future conflict induces the country with less resource wealth to “prey” on the relatively more “prudent” behavior of its larger rival, and more so as conflict becomes more likely. While a shift from autarky to trade always raises the current incomes of both countries, the smaller country realizes the relatively larger income gain from trade and also devotes a relatively larger share of its income gain towards arming. Our analysis shows that the larger country rationally chooses not to trade today when the difference in initial resource wealth is sufficiently large and is more likely to prefer autarky when the probability of future conflict is higher.