Understanding Bargaining Situations and Negotiations in Game Theory

Introduction to Game Theory For Ansal University PGT students, September 2019 Abhinay Muthoo University of Warwick Slides #3: Negotiations and Bargaining Games

Bargaining Situations and some examples A bargaining situation is a situation in which two or more players have a common interest to cooperate, but have conflicting interests over exactly how to cooperate. Examples from Economic Interaction: Buying a house, M&A, IP Royalty, Pay Increase. Examples from Political Interaction: Brexit Negotiations, Budget Allocation across Government Departments, Leadership of the Tory Party Examples from Social Interaction: Marriage, Divorce, Friends. 3/20/2025 Abhinay Muthoo, University of Warwick 2

Main Questions of Interest (Efficiency Question): Will the parties reach an agreement or will they do so after some costly delay or will they not reach agreement at all? (Distribution Question): If agreement is reached, then what are the agreed terms? That is, who gets what. [Main Factors] What are the main variables (or factors) that determine the bargaining outcome? [Bargaining Power] What are the main sources of bargaining power and what strategies can help improve one s bargaining power? 3/20/2025 Abhinay Muthoo, University of Warwick 3

Impatience Bargaining i.e., the making of offers and counteroffers, and other actions taken in the negotiation process takes time. Time is valuable. Parties will value time differently for various reasons. Reaching a deal requires compromise, and this factor ( Impatience ) gives the parties appropriate incentives to do so. Main Insight: The less impatient a negotiator is relative to the other negotiator(s), the higher is her bargaining power relative to the other negotiator(s); and thus, if agreement is reached, it will be relatively more favourable to her. 3/20/2025 Abhinay Muthoo, University of Warwick 4

Risk of Breakdown In many negotiations, there are exogenous risks might be very small but exist - that negotiations might breakdown in disagreement. Randomly something occurs and parties walk away. For example, when negotiating the sale of one s house with a potential buyer, a different buyer randomly turns up and offers to buy at a good price. Negotiators will have differing attitudes (or aversions) to risk, for various reasons. Main Insight: The less risk averse a negotiator is relative to the other negotiator(s), the higher is her bargaining power relative to the other negotiator(s); and thus, if agreement is reached, it will be relatively more favourable to her. 3/20/2025 Abhinay Muthoo, University of Warwick 5

Outside Options A player s Outside Option is her best alternative to a negotiated agreement - her BATNA. That is, it her payoff from permanent disagreement. A negotiator s outside option is a key source of her bargaining power provided the outside option payoff is sufficiently attractive. If so, then her bargaining power increases as the attractiveness of the outside option increases. If the outside option payoff is not attractive enough, then it has no impact on the bargaining outcome. It is not credible to threaten to walk away from the negotiations and exercise one s outside option if that outside option payoff is not attractive enough. Main Insight (The Outside Option Principle): If a negotiator s outside option is not sufficiently attractive, then the outside option is useless and has no impact on the outcome. But if it s sufficiently attractive, then her bargaining power increases as the value of her (attractive) outside option increases and any agreement struck will reflect that. 3/20/2025 Abhinay Muthoo, University of Warwick 6

Inside Options A player s Inside Option is his payoff while there is temporary disagreement but the negotiations are still in motion. To illustrate consider marital negotiations: Divorce is a spouse s outside option, while, for example, sleeping on the couch or in the spare bedroom is his inside option! Main Insight: A negotiator s bargaining power increases as the value of his inside option increases. As another example: During Union-Firm Wage negotiations, the strike fund is the Union s inside option as it would access that fund when workers go on strike (temporary disagreement). 3/20/2025 Abhinay Muthoo, University of Warwick 7

Commitment Tactics A tactic that is sometimes deployed to try to improve one s negotiating position is the Commitment Tactic: The negotiator takes actions (prior to and/or during the negotiations) that commit (or bind) herself, to some extent, to some selected bargaining position. To illustrate, consider the BREXIT negotiations. The Prime Minister making public statements at various points about her red lines is an instance of her using such a tactic. Such commitments can be revoked during the negotiations but doing so can be costly. Main Insight: A player s bargaining power is higher, the larger are its costs of revoking its partial commitments. It is as if, in bargaining, weakness , can be a source of bargaining power. 3/20/2025 Abhinay Muthoo, University of Warwick 8

Asymmetric Information In many bargaining situations, a player may have private information about some relevant variable or parameter private in that only he knows it and not the other negotiators. As an example, a buyer s value (maximum willingness to pay) for a house will only be known to her and not to the seller while they negotiate over its sale price. Main Insights: (i) The presence of asymmetric information increases the likelihood of costly delays (such as strikes and wars) in reaching agreement or a total failure to reach any agreement; (ii) Information is power in negotiations, and a party with private information may be able to get a better deal if one is reached. 3/20/2025 Abhinay Muthoo, University of Warwick 9