Bargaining

Sukanta Bhattacharya

Sep-Dec 2019

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Bargaining

The total payoff that the parties to the negotiation are capable of
creating and enjoying as a result of reaching an agreement should be
greater than the sum of the individual payoffs that they could achieve
separately.
I The whole must be greater than the sum of the parts.
I Without the possibility of this excess value (surplus), the negotiation
would be pointless.
Bargaining is not a zero-sum game.
I When a surplus exists, the negotiation is about how to divide it up.
I Each bargainer tries to get more for himself and leave less for the
others, but if the agreement is not reached nobody gets anything.

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Resolution of bargaining problem

Two approaches:
1 Bargaining as a cooperative game, in which the parties find and
implement a solution jointly, perhaps, using a neutral third party such
as an arbitrator for enforcement.
2 Bargaining as a non-cooperative game, in which the parties choose
strategies separately and we look for an equilibrium.

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Cooperative solution: an example

Mr. A and Mr. B have their default options a and b - reservation

payoffs.
However, if they join hands they can together generate value v where

v >a+b

The surplus v − a − b > 0.

Each player is to be given his reservation payoff plus a share of the
surplus, a fraction α of the surplus for A and a fraction β for B, such
that α + β = 1.
α and β specify the bargaining powers of A and B respectively.
No theory about what determines α and β.

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Nash Bargaining Protocol
Writing x for the amount that A finally ends up with, and similarly y
for B,
x = a + α (v − a − b)
⇔ x − a = α (v − a − b)
and
y = b + β (v − a − b)
⇔ y − b = β (v − a − b)
Combining we get,
x −a α
=
y −b β
To use up the whole surplus, x and y must also satisfy
x +y =v
The Nash outcome x and y are actually the solutions to these last
two equations.
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Nash Bargaining Protocol

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Points to note

Notice that the outcome is not a result of any strategic play by the
players and the resulting equilibrium.
Unlike the non-cooperative game, the players reach an agreement
jointly and then think about how to implement it.
May be hand the implementation part over to a third party like an
arbitrator.

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What is a good outcome?

The theory defines the outcome of a cooperative game in terms of

some general principles or properties that seem reasonable to the
theorist.
Nash formulated a set of principles for bargaining and proved that
they implied a unique outcome.
Nash principles:
1 The outcome should be invariant if the scale in which the payoffs are
measured changes linearly.
2 The outcome should be efficient.
3 If the set of possibilities is reduced by removing some that are
irrelevant, in the sense that they would not be chosen anyway, then the
outcome should not be affected.

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Nash outcome
Nash proved that the cooperative outcome that satisfies all three of
these assumptions could be characterized by the mathematical
maximization problem:
choose x and y to maximize

(x − a)α (y − b)β

subject to
y = f (x)
where y = f (x) specifies the efficiency frontier.
In our case, the efficiency frontier is

y =v −x

Easy to verify that the outcome at Q in the last figure is a solution to

the above problem and satisfies all three Nash principles.
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Variable threat bargaining

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Variable threat bargaining

If Mr. A can improve his reservation payoff, his ultimate payoff

improves in the final bargaining outcome.
But an worsening of the reservation payoff of Mr. B will also have
similar impact on Mr. A’s post-bargaining payoff.
This gives the players incentive to manipulate the reservation payoffs
at the pre-bargaining stage.
But that is another game!!!

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Non-cooperative bargaining: Ultimatum Game Once Again

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Reservation payoffs in Ultimatum Game

In backward induction equilibrium, player 1 gets almost 100 and

player 2 gets nothing.
Notice that players’ reservation payoffs are 0.
If player 2’s reservation payoff becomes 50, player 1 has to offer at
least 50 to player 2.
The split depends on the reservation payoffs of the players and the
there is an excess value if and only if the sum of the reservation
payoffs is less than 100

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Alternating offer bargaining: Total value decays

Two rounds with reservation payoffs 0

Suppose if player 2 rejects player 1’s first round offer, player 2 himself
gets a chance to make an offer which player 1 either accepts or
rejects.
However, if player 2 rejects player 1’s first round offer, the value of
surplus gets reduced by 10, i.e. becomes 90.
Notice that post first round rejection by player 2, the two players play
an ultimatum game with player 2 as the proposer and total surplus 90.

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Alternating offer bargaining: Two rounds

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Equilibrium in two round version

Round 2 game being an ultimatum game, the proposer (player 2) will

offer y = 90 (almost) which player 1 will accept.
Anticipating this, player 1 wiould offer x = 90 in round 1. Player 2
accepts.
Thus in the backward induction equilibrium, player 1 ends up with 10
while player 2 would have 90.
Notice that there is no delay in reaching an agreement.

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The general case

If offers are rejected for 10 consecutive rounds, there is nothing left

on the table to bargain over.
Consider the 10th round first. The remaining surplus is 10.
Player 2 being the proposer in this final round will keep the remainig
surplus for himself.
Anticipating this, in the 9th round (remaining surplus 20) player 1 will
offer 10 to player 2 which will be accepted. Player 1’s share will be 10.
In the 8th round (remaining surplus 30), player 2 will offer 10 to
player 1 and keep 20 for himself.
In the 7th round (remaining surplus 40), player 1 will offer 20 to
player 1 and keep 20 for himself and so on.

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Backward Induction Equilibrium

We can see the pattern. In the odd rounds (when player 1 is the
proposer) he will propose a 50 − 50 split of the remaining surplus and
the offer will be accepted.
In backward induction equilibrium, player 1 will offer a 50 − 50 split in
the first round and the offer will be accepted because player 2 cannot
do any better by rejecting the offer.
Important points:
1 The agreement is reached in the first period with no delay.
2 Gradual decay (several potential rounds of offers) leads to a more even
or fairer split of the total than does sudden decay (only one round of
bargaining permitted).

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Alternating offer bargaining: Impatience

In this version, the surplus available for splitting does not decay, but
players’ valuations of future payoffs are different from their valuations
of present payoffs.
Rs.100 now is more valuable than Rs.100 next month.
Possible reasons: uncertainty about future, inflation, investment
opportunities to earn a positive return.
As before, the players take turn in making offers and the game
continues till one offer is accepted.

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Discount factor

Suppose if a player earns Rs.1 now and invests it, he will get back
Rs.1 + r next period where r is the per period return on Rs.1.
Thus, Rs.1 now is equivalent to Rs.1 + r one period later.
1
Alternatively, Rs.1 one period later is equivalent to Rs. 1+r now.
We write
1
=δ<1
1+r
and call it the per period discount factor.
δ reflects the degree of patience of a player.
Higher the value of δ, the more patient the concerned player is.

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Equilibrium with same degree of patience for both players

Suppose player 1 makes the first offer.

If player 2 rejects player 1’s offer, then player 2 will have an
opportunity to make his own offer one period.
The two bargainers are in identical situations when each makes his
offer, because the amount to be split is always Rs.100.
In equilibrium the amount that goes to the person currently in charge
of making the offer (call it x) is the same, regardless of whether that
person is 1 or 2.

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Equilibrium with same degree of patience for both players

When player 1 makes the first offer, he knows that rejecting it player
2 can get x in the next period when it is 2’s turn to make the offer.
But x next period is equivalent to δx in the current period.
Hence, player 1 will offer player 2 δx this period to induce acceptance
and keep 100 − δx for himself.
But the amount that player 1 gets when making the offer is just what
we called x. Hence,
100
x = 100 − δx ⇔ x =
1+δ
1 δ
In equilibrium, player 1 gets 1+δ .100 and player 2 gets 1+δ .100̇

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Points to note

1 Even though the process allows for an unlimited sequence of

alternating offers and counteroffers, in the equilibrium the very first
offer player 1 makes gets accepted and the bargaining ends
I Because players are impatient, the outcome is efficient.
I The degree of patience determines how much must be offered to induce
acceptance from player 2. Higher is δ, more is the share of player 2.
2 The player who makes the first offer gets more than half of the pie
1 δ
>
1+δ 1+δ

I But this advantage is far smaller than that in an ultimatum game with
no future rounds of counteroffers.

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