Part IV: Bargaining Games

1 Chapter 18: Bargaining Problems

2 Chapter 19: Analysis of Simple Bargaining Games

3 Chapter 20: Games with Joint Decisions; Negotiating Equilibrium

4 Chapter 21: Unverifiable Investment, Hold Up, Options, and

Ownership
Chapter 18: Bargaining Problems
 Value creation and division

Trade creates value.

How will this value get divided among the traders?
Depends on
bargaining strengths,
procedure by which negotiation takes place and
general contracting environment.
Negotiation and value creation do not have to entail a direct
exchange.
 Abstract Representation of Bargaining
Problems

Two players deciding whether to start a partnership.

Payoff vector for forming a partnership: (4,6).
Payoff vector for not forming a partnership: (2,2).
V = {(4, 6), (2, 2)} is the bargaining set.
Let d denote the default outcome or disagreement point. In
this game d = (2, 2).
Players can agree to a monetary transfer t as a part of the
contract.
Other items for negotiation are represented by z.
 Abstract Representation, continued

Money enters additively if u1 = v1 (z) + t and u2 = v2 (z) t.

Transerable utility: when payoffs are additive in money.
Let z = 1 represent forming a partnership and z = 0 represent
not.
v1 (0) = v2 (0) = 2, v1 (1) = 4 and v2 (1) = 6.
If bargaining is resolved with z = 0, then player 1 gets 2 + t
and player 2 gets 2 t.
If the players agree to z = 1, then player 1 obtains 4 + t and
player 2 receives 6 t.
All vectors of the form (4 + t, 6 t) and (2 + t, 2 t) are in
the bargaining set.
 Abstract Representation, continued

The set of efficient outcomes is those that maximize the

players joint value the sum of the players payoffs.
That is represented in this problem by the line going through
(4,6).
What about the set represented by the line going through
(2,2)?
t is merely a transfer and gets canceled out in the joint-value
calculation
[v1 (z) + t] + [v2 (z) t] = v1 (z) + v2 (z)
Surplus the difference between the joint value of the
contract and the joint value that would have been obtained
had the players not reached an agreement.
Surplus = v1 (z) + v2 (z) d1 d2
 Example of a bargaining problem

Rosemary, chair of English dept. at high school; Jerry a

potential teacher.
Negotiate over:
whether to initiate an employment relationship
Jerrys responsibilities on the job, x.
Jerrys salary t.
Joint value at x = 1 > Joint value at x = 0. Why?
 Standard Bargaining Solution

Let v be the maximized joint value of a bargaining game.

Players do not negotiate over v ; they negotiate over the
surplus = v d1 d2 .
Neither player will accept anything less than their own
defaults. Why?
Bargaining weight i denote the proportion of the surplus
obtained by player i.
The standard bargaining solution is a mathematical
representation of efficiency and proportional division.
 Legal Default Rules

Story of cattle rancher and corn farmer.

No fence between the ranch and farm; ranchers cattle free to
enter farmers field and destroy some of his corn.
$100 to build and maintain a fence.
Legal rule 1: farmer has right to use his land without
interfence.
Legal rule 2: rancher has right to let her cattle roam freely.
Coase: it does not matter which legal rule is adopted.
Under well-defined property rights and efficient contracting,
the efficient outcome will always be reached.
The Coase Theorem is not without caveats.
Chapter 19: Analysis of Simple Bargaining Games
 Ultimatum Game

In this chapter, we will use noncooperative game theory to study

bargaining.
Recall game where buyer and seller negotiate the price of a
painting.
Helpful to normalize surplus to 1.
Player i offers fraction m of surplus to Player j, who accepts
or rejects.
For m > 0, if Player j accepts, he gets m and i gets 1 m;
rejecting leads to 0 for both.
There is a unique SPNE.
 Two-Period Alternating-Offer Game

Ultimatum game too simplistic a model of most real-world

negotiation.
Consider a game where player 1 offers m1 in Period 1, Player
2 accepts or rejects.
If Player 2 rejects, he counteroffers m2 . Player 1 accepts or
rejects.
Payoffs are discounted by discount factor 0 < 1.
Each subgame starting in the second period is just the
ultimatum game.
Again we have a unique SPNE.
 Some comments

Patience is positively related to bargaining power.

1 = 1 2 and 2 = 2 .
This can be generalized to a T -period game.
The SPNE in the 2-period and T-period games are efficient:
players reach agreement in first period.
Does not capture delay and inefficiency which are regular
occurrences in real life.
People do not always have complete information.
 Infinite-Period Alternating-Offer Game

Consider alternating-offer game that runs for a potentially

infinite number of periods.
Subgames starting from any period t exactly same as
subgames starting from period t + 2.
Let m2 be the offer that player 1 would make in
odd-numbered periods (when he has the offer)
Let m1 be the offer that player 2 would make in
even-numbered periods.
Player is equilibrium offer makes player j indifferent.
Indifference means i (1 mj ) = mi and j (1 mi ) = mj .
Solve these two equations to obtain m1 and m2 .
 Some comments

Player is equilibrium payoff increases as i rises.

It decreases as j falls.
For the special case of 1 = 2 = , equilibrium payoffs
converge to 1/2 as approaches 1.
If players are equally patient, they split surplus evenly;
1 = 2 = 1/2.
 Multilateral Bargaining

3 districts in a metro area bargaining overs surplus from new

project.
Player i makes offer in period i; cycle continues until
agreement.
Voting rule is unanimity.
In a given period, one player has the right to make a proposal
x = (x1 , x2 , x3 ), where xi denotes the amount offered to player
i.
Suppose proposer offers x n to player next to propose and x l
to player who proposes after that. (n for next, l for last)
Let x p be amount proposer offers for herself.
Assume a common discount factor .
 Multilateral Bargaining, continued

Intuition from two-player, infnite-period model carries over.

Player who gets to make first proposal fares better.
Equity arises as discount factor converges to 1.
As goes to 1, x p , x n and x l all converge to 1/3.
Chapter 20: Games with Joint Decisions;
Negotiating Equilibrium
 Joint Decisions

Joint-decision node is an abbreviated description of

negotiation between players over some tangible objects.
We specify a joint decision when we dont want to create a
full noncooperative model of the negotiation process.
Branches at a joint-decision node represent alternatives to
players as a group.
One of the branches must be the default decision.
Tree Rule 4 is replaced by Tree Rule 6: For each
information set, all included nodes must be decision nodes for
the same subset of players that is, belonging to either a
single player or, in a joint decision, the same group of players.
 Some comments

Branches correspond to tangible items over which the parties

spot contract, i.e. automatically enforced.
This may affect future behavior, but can be enforced
externally, by a court, for example.
Why joint decisions make a good modeling tool:
Using an abbreviated model of negotiation, we can emphasize
other aspects of a strategic situation while still capturing the
intuitive notion of bargaining power.
Further benefit of helping us differentiate between the process
of negotiation and what the players are negotiating over.
Joint decisions mark the places in a game where contracting
takes place.
 Negotiation Equilibrium

Combine backward induction or subgame perfection with

standard bargaining solution.
Regime: A specification of behavior at every information set;
generalization of strategy to include joint decisions.
Negotiation Equilibrium: if description of a regimes
behavior at individual decision nodes is consistent with
sequential rationality and its specification of joint decisions is
consistent with the standard bargaining solution, for given
bargaining weights.
We will ignore two issues:
Backward induction and/or subgame perfection may not be
easily employed in some games.
There may be no transferable utility.
 Contracting for High-Powered Incentives

Carina and Wendy wish to start a bookstore together.

Carina suffers some disutility when asked by customer for a
price reduction.
Wendy notes that this disutility is more than offsent by gain in
store profit from maintaining a fixed-price policy.
High-powered incentives compensate people conditional
on their direct contribution to output work well if
contribution is verifiable.
Chapter 21: Unverifiable Investment, Hold Up,
Options, and Ownership
 Hold-Up

Timing:
At Date 1, Joel Dean (JD) decides how much to invest in
design of medical device (High (H), Low (L) or No (N)),
which Brynn observes, but court doesnt.
At Date 2, JD and Brynn meet to negotiate (court
enforceable) monetary transfer p from Brynn to JD iff Brynn
decides to produce at Date 3.
At Date 3, Brynn chooses to produce (P) or not (N).
 Hold-Up, continued...

Court compels p = 0 if Brynn selects N.

JD = B = 1/2.
If Brynn selects P, her payoff is 4 if JD chooses L and 18 if JD
chooses H.
If Brynn selects N, she gets 0 regardless of JDs choice.
JD choosing H and Brynn choosing P is efficient. Why?
Yet, only rational action of JD is to invest at level L.
Brynn extracts a significant share of the benefit of JDs
investment, under the threat of holding up production.
 Up-Front Contracting and Option
Contracts

In hold-up example, JD and Brynn meet after JD makes

investment decision.
Consider when JD and Brynn form initial contract at Date 0.
Any contracting at Date 2 after JDs investment decision at
Date 1 is renegotiation.
At Date 0, JD and Brynn jointly select p and may also specify
up-front transfer.
Hence p is the default for renegotiation at Date 2.
Assume default decision at Date 0 is p = 20.
 Up-Front Contracting and Option
Contracts, continued

Hold-up is still a problem.

JDs investment decision is unverifiable; no way to give JD a
high-powered incentive to invest.
Recall Carinas example in Chapter 20.
Contracts that specify p > 18 or p < 4 are called forcing
contracts.
An option contract creates different incentives for Brynn,
depending on JDs investment.
Helpful in situations with unverifiable investments.
Used in many real settings, e.g. procurement and innovative
industries.
 Asset Ownership

Barriers to writing detailed contracts:

Can be costly, e.g. lawyer fees.
Difficult to imagine all contingencies.
Alternative: judiciously allocate asset ownership.
Consider extension of JD-Brynn game.
Production requires use of an asset.
JDs investment amounts to configuring this asset.
 JD-Brynn game with asset ownership

Following JDs investment, best use of asset is by Brynn.

But the asset may be used for production by a different
engineer company.
Competition between these other companies means JD
extracts full surplus if he owns the asset.
With alternative producer, revenue is 0 and y with low and
high investment by JD respectively, with 0 < y < 18.
Low y = JDs investment is specific; otherwise it is
general.
 JD-Brynn game with asset ownership,
continued

At t = 0, JD and Brynn can decide on ownership of asset but

nothing else.
Rest of the game is similar to original game.
Will giving ownership of asset to JD encourage him to invest
H?
Yes, if JDs investment is sufficiently general; y 4 to be
precise.