An introduction to bargaining

Bargaining situations are ubiquitous, for example: a potential buyer of a car will bargain
with a car salesperson; unions bargain with firms over wages and conditions; and buyers
haggle for a better deal with vendors at a bazaar. This note presents an introduction to
how prices are determined when two parties negotiate with one another to determine a
price. By its very nature bargaining is a complicate affair: no two bargaining situations
are ever going to be exactly alike. However, the approach is here to simplify a bargaining
process to try to get some general lessons about what happens when two parties come
together to make a deal.

Two-person bargaining: a take-it-or-leave-it offer game

To start, assume there are two parties A and B. If they trade a good y (A can be the seller
and B the buyer) B gets $1 of benefit. A does not value the good at all (A has $0 value for
the good) so there is a potential trade.
How is the price of the good going to be determined? Assume the negotiations between A
and B have the following structure: A makes a price offer to B, for example Dear B, if
you pay me $x I will sell you this good; B then can accept the offer and trade will take
place at As suggested price, if not, no trade takes place and A and B part company
immediately. (Assume that if no trade takes place A has $0 benefit and that B also has $0
benefit, as she does not have the good.)
Figure 1 provides a diagrammatically illustration of this bargaining situation.
To solve the problem of what price A will offer, A will consider what B will do given the
offer he has made. What if A makes an offer of a price greater than $1? B will reject any
offer of a price over $1 as B only values the good at $1; for such a high price she is better
off not buying the good. What about an offer below $1? If B accepts a price offer below
$1 (for example an offer of x), B will get benefit $1 x > 0. In other words, she is better
off buying the good than not buying. B will buy the good for any price up to $1, so A
should set a price as high as possible at $0.99 or even $1! B is obviously disadvantaged
by such a high price, but will still buy the good because buying is still (just) better than
not buying the good or at least no worse off.

An introduction to bargaining Andrew Wait

Figure 1.

Take-it-or-leave-it offer

A makes price offer of x

B
Accept

A gets x; B gets 1 x

Reject

A gets 0; B gets 0

It is important to note that this problem is solved backwards A anticipates Bs

behaviour, then sets his price offer accordingly. To work out what the best price offer is,
party A first thinks about Bs action.
The second point of this model is that the person making the offer gets all (or nearly all)
the benefits from trade. Why? That person knows that if the other party does not accept
this offer no trade will occur at all. This kind of offer is often called a take-it-or-leave-it
offer; B can either accept the offer or go home. The bargaining model is also sometimes
called an ultimatum game. Consequently, the party getting to make a take-it-or-leave-it
offer has all the bargaining power, and they will capture all (or almost all) the benefits of
trade.
Although it illustrates a useful point, this game is quite unusual in that bargaining ends
after only one period (or one offer). If A can credible commit to his initial offer, the
ultimatum game is appropriate. This may not always be the case, however.
What if B gets to make another offer before the end of the game? To formalise this
consider the new game illustrated in Figure 2. The game starts as before A makes an
offer (x) to B and B can accept or reject the offer. If B accepts the offer trade takes place
at that price. If B rejected the offer B then has the opportunity to make a counter offer to
A (B suggests price z). If A accepts this offer trade takes place at Bs suggested price. If
A rejects Bs offer the two part ways that is, no trade takes place and they each
receive a payoff of $0.

An introduction to bargaining Andrew Wait

Figure 2.

Two period bargaining model

A makes price offer of x

Accept

B
Reject

A gets x; B gets 1 x
B makes price offer z

Accept

Reject

A gets z ; B gets 1 z

A gets 0; B gets 0

Again, to find the outcome of this scenario, move from the last stage and work backwards.
In the very last stage of this bargaining situation, A can accept Bs price offer and receive
a payoff equal to the price, or he can reject the offer and get $0. A will then have an
incentive to accept any price offer from B that gives him at least $0 that is, any price
p $0. Anticipating As behaviour in the last period, B will set a price that A will be
willing to accept in this case she can make a price offer of p = $0.
Now consider what happens in the first bargaining round. If bargaining reaches the
second round B will receive all of the surplus. As a result, she will be unwilling to accept
an offer from A that gives her less than this payoff. (To guarantee herself a price of $0.00
all B needs to do is reject As offer.) A anticipates this. A could offer a high price,
knowing that this offer will be rejected, anticipating Bs counteroffer of p = $0.00 that he
will accept. Alternatively A can give in to the inevitable and offer a price of p = $0.00
and get the whole process over with. (In this set-up either outcome is possible.)
In this bargaining situation B gets all of the surplus her bargaining power comes from
the fact that she gets to make the last offer. Knowing this, B can extract all of the surplus.
Although not enthusiastic about the situation, A knows that he cannot do anything about
it B has all of the bargaining power.
In the first game A had all of the bargaining power and received the entire surplus. In the
second bargaining game, B had all of the bargaining power and received the whole
surplus. In both cases it was the opportunity to make the final offer before the opportunity

An introduction to bargaining Andrew Wait

to trade disappeared that was crucial this gave that party all of the bargaining power and
allows that party to capture all of the surplus.
Other factors could affect the distribution of bargaining power. The parties may not know
when bargaining is going to end. For example, a car salesperson may not know when she
will be called by her boss into an urgent meeting, ending negotiations. A union official
may not know the negotiation deadline of the firm or of union members. If a party thinks
that negotiations are likely to end after a particular bargaining round, this will affect the
offers that they are likely to accept. Further, the two parties may have different
understandings about the probability that bargaining will end. In most cases, the party
with the higher anticipated probability of breakdown will have less bargaining power and
get less of the surplus.
Similarly, there could be costs of the bargaining process: for example, worker may forgo
their wages while on strike; firms may lose production and profits. Again, as a general
rule, the higher a partys costs of bargaining are relative to the other player, the less
bargaining power they will have.
As a final point in this section, many economists have tried to set up experiments to see if
bargaining parties actually play the strategies that theory would suggest in situations like
those illustrated in Figure 1 (the ultimatum game). It turns out that people often make
offer of around $0.50 and these offers are accepted. Further, it seems people will reject
offers of particularly high prices (like prices over $0.80) even though this makes the
rejecting party worse off. A great deal of effort has gone into explaining these results. For
example, on explanation is that people value fairness. Another explanation relates other
factors outside of the model we have presented. For example, if the game between the
parties is played many times (not just once) the parties may cooperate (or collude),
resulting in a price that shares the benefits between the parties.

Outside opportunities
Thus far, it has been assumed that the two parties can only deal with each other, and if
they fail to do so there is no trade. What if there are third parties that A and B can trade
with. To simplify the analysis consider the case when A cannot deal with any other party
but B knows that if trade breaks down with A, she can go and trade with another party.
From trading with the third person (or her outside option) assume that B gets a benefit of
$0.60 with certainty. In all other respects, the bargaining situation is the same as the
ultimatum game illustrated in Figure 1.
What will be the outcome of this game? Again working backwards, B will reject any
offer from A that do not give her at least $0.60 benefit, because she can always go and
get her outside option. As a result, B will only accept offers p $0.40. Now consider As
move. A realises that B will reject any price greater that $0.40, so he will offer a price
p = $0.40. The outcome of the game is then A offer a price of $0.40 and B accepts this
price.

An introduction to bargaining Andrew Wait

The presence of an outside option has improved Bs claim on the benefits of the trade,
although she does not get to make an offer in this game. This helps explain why
bargaining agents find it advantageous to limit the outside options of the other parties if
they can. For example, a union may wish to enforce a closed shop on a particular
workplace, requiring the firm to only employ members from that union.
Finally, it is worth noting that an outside option may not always improve a partys claim
on surplus. For example, B may have the option to trade with party C, but both A and B
know that C is identical to A. As a consequence, if B stops negotiating with A and starts
negotiating with C, B will be in exactly the same position as she was before. Any threat
then to terminate bargaining with A may not be taken so seriously.

Breakdown in bargaining
As evidenced from real negotiations, bargaining parties do not always come to an
agreement. Further, negotiations are sometimes protracted and costly for everyone
involved. For example, some union negotiations with firms involve many hours of
meetings, strikes, lock-outs and lost production. The models presented above to not
explains these delays in bargaining. In all of the models above, the trading parties realise
all of the potential gains from trade.
One explanation for breakdown in bargaining is that there is some asymmetric
information between the parties. Consider the ultimatum game again with one slight
modification; assume that A does not know whether B values the good at $1 or at $0.50.
If A believes with a very high probability that B values the good at $1 (for example, that
98 times out of 100 B will have a value of $1) A may simply continue to make an offer of
$1. Presuming As beliefs are correct, 98 times out of 100 B will purchase the good.
However, 2 times out of 100 B will decline the offer. In these cases a potential trade will
not occur, and the potential benefits will not be realised.
Asymmetric information can also explain why a deal may only be agreed upon after a
costly period of negotiation, like after a strike or a lock-out. In this case the parties may
have no way to communicate their bargaining strength without enduring a burden that a
weaker bargaining agent could not bear to do. For example, suppose that a firm can be a
weak or a strong bargainer; the weak bargainer cannot survive a strike while the firm in
the strong bargaining position has a stockpile and can survive a long strike. The union,
however, does not know whether the firm is weak or strong. From the arguments above,
the strong firm should receive a better deal in its negotiations with the union (that is, a
lower wage). However, it may be that the only way a strong firm can communicate with
the union that it is in fact strong is by enduring a lengthy strike that the weak firm would
not be willing (and able) to manage. After the strike has determined that the firm is
indeed a strong bargaining agent, the union will acknowledge the firms strength and
concede to an agreement with a low wage.

An introduction to bargaining Andrew Wait

Concluding comments
When there are limited potential trading parties, negotiations between the parties will
determine the division of the gains from trade. Other things equal, a party will receive a
greater share of the benefits the greater their relative bargaining power. Bargaining power
can arise if a party has the ability to credibly make the final offer. Bargaining power is
also typically reduced when a party has higher bargaining costs and if it believes that
negotiations will break down with a high probability. If a party has an outside option (for
example, the option to trade with another party) this may increase their share of the gains
from trade.
Bargaining is not always efficient in that not all of the gains from trade are always
realised. One possible reason is that the parties have asymmetric information about each
other. This may cause bargaining to breakdown entirely; alternatively, the parties may
endure costly negotiations before reaching an agreement.

References
This note draws heavily on the following papers:
Neilson, W. and H. Winter 1998, Intermediate Microeconomics, South-Western
Publishing, Cincinnati, pp. 350-359.
Schelling, T. 1956, An Essay on Bargaining, American Economic Review, vol. 46, no. 3,
pp. 281-306.
Shaked, A. and Sutton, J. 1984, `Involuntary Unemployment as a Perfect Equilibrium in a
Bargaining Model', Econometrica, vol. 52, no. 6, pp. 1351-64.
Rubinstein, A. 1983, Perfect Equilibrium in a Bargaining Model, Econometrica, vol. 50,
no. 1, pp 97-109.
Varian, H. 2003, Intermediate Microeconomics: A Modern Approach, Sixth edition,
Norton and Company, new York, pp. 535-538.
Williamson, O. 1983 Credible Commitments: Using Hostages to Support Exchange",
American Economic Review, Vol. 73, pp. 519-40

An introduction to bargaining Andrew Wait