Game Theory

Necessity Never Made

a Good Bargain.
- Benjamin Franklin

Mike Shor
Lecture 13

Economics

Allocation of scarce resources

Many buyers & many sellers

traditional markets

Many buyers & one seller

auctions

One buyer & one seller

bargaining
Game Theory - Mik

Role of Game Theory

Design non-traditional markets

Market Design, Inc.

Charles River Associates
NERA Economic Consulting
Open Options
LECG
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The Move to GameTheoretic Bargaining

Baseball

Meet-in-the-Middle

Each side submits an offer to an arbitrator who

must chose one of the proposed results
Each side proposes its worst acceptable offer
and a deal is struck in the middle, if possible

Forced Final

If an agreement is not reached by some

deadline, one party makes a final take-it-orleave-it offer

Game Theory - Mik

Bargaining & Game Theory

Art:

Negotiation

Science:

Bargaining

CAVEAT: Limited Applicability

Game Theory - Mik

The Contribution
of Game Theory

Importance of rules:
The rules of the game
determine the outcome

Diminishing pies:
The importance of patience

Estimating payoffs:
Trust your intuition
Game Theory - Mik

Take-it-or-leave-it Offers
Consider the following bargaining
game over a cake:
I name a take-it-or-leave-it split.
If you accept, we trade
If you reject, no one eats!

Under perfect information, there is a

simple rollback equilibrium
Game Theory - Mik

Take-it-or-leave-it Offers

accept

1-p , p

reject

0,0

Game Theory - Mik

Rollback

Consider the subgame:

Accept: 1-p , p
Reject: 0 ,
0

You will accept if p>0,

reject otherwise
Rollback: I will offer the smallest
acceptable piece (i.e. almost none)

What if you make the take-it-orleave-it offer?

Game Theory - Mik

Take-it-or-leave-it Offers
Simple to solve
Unique outcome
Unrealistic

Ignore real bargaining

Assume perfect information
Not credible
If you reject my offer,
will I really just walk away?

Game Theory - Mik

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Counteroffers and
Diminishing Pies

In general, bargaining takes on a take-itor-counteroffer procedure

If time has value, both parties prefer

trade earlier to trade later

E.g. Labor negotiations

later agreements come at a price
of strikes, work stoppages, etc.
Game Theory - Mik

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Multi-stage Bargaining

Bargaining over division of a cake

I offer a proportion, p, of the cake

If rejected, you counteroffer
(and of the cake melts)
Payoffs:
In first period: 1-p , p
In second period: (1-)(1-p) , (1-)p

Game Theory - Mik

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Rollback
What happens in period 2?
Since 2 is the final period, this is
just like a take-it-or-leave-it offer:

You will offer me the lowest price that I

will accept, leaving you with all of 1-
and leaving me with almost 0

What do I do in the first period?

Game Theory - Mik

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Rollback

Give you at least as much surplus

Your surplus if you accept
in the first period is p

Accept if:

Your surplus in first period

Your surplus in second period
p 1-
Game Theory - Mik

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Equilibrium

If there is a second stage,

you get 1- and I get 0.

You will reject any offer in the first stage

that does not offer you at least 1-.

In the first period, I offer you 1-.

Note: the more patient you are (the

slower the cake melts) the more you
receive now!
Game Theory - Mik

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First or Second Mover

Advantage?

Are you better off being the first to

make an offer, or the second?

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Example: Cold Day

If =1/5 (20% melts)
Period 2: You offer a division of 1,0

You get
I get

all of remaining cake

0

= 0.8
=0

In the first period, I offer 80%

You get
I get

80% of whole cake

20% of whole cake

Game Theory - Mik

= 0.8
= 0.2

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Example: Hot Day

If =4/5 (80% melts)
Period 2: You offer a division of 1,0

You get
I get

all of remaining cake

0

= 0.2
=0

In the first period, I offer 20%

You get
I get

20% of whole cake

80% of whole cake

Game Theory - Mik

= 0.2
= 0.8

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First or Second Mover

Advantage?
Who has the advantage?
Depends on the value of the future!

If players are patient:

Second mover is better off!

If players are impatient

First mover is better off!
Game Theory - Mik

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Information
COMMANDMENT
In any bargaining setting,
strike a deal as early as possible!

Why doesnt this happen?

Time has no meaning
Lack of information about values!
Reputation-building in repeated settings!
Game Theory - Mik

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Examples

British Pubs and American Bars

Civil Lawsuits
If both parties can predict the future jury
award, can settle for same outcome and
save litigation fees and time
If both parties are sufficiently optimistic,
they do not envision gains from trade

Game Theory - Mik

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Uncertainty I:
Civil Trial
Plaintiff sues defendant for $1M
Legal fees cost each side $100,000
If each agrees that the chance of the
plaintiff winning is :

Plaintiff: $500K-$100K = $ 400K

Defendant:
-$500K-$100K = $-600K

If simply agree on the expected

winnings, $500K, each is better off
Game Theory - Mik

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Civil Trial
What if both parties are too
optimistic?
Each thinks that their side has a
chance of winning:

Plaintiff:
Defendant:

$750K-$100K = $ 650K
-$250K-$100K = $-350K

No way to agree on a settlement!

Game Theory - Mik

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Uncertainty II:
Non-monetary Utility

Labor negotiations are often a simple

game of splitting a known surplus

Company will profit $200K

how much of this goes to labor?

Rules of the bargaining game uniquely

determine the outcome if money is the
only consideration
Game Theory - Mik

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Non-monetary Utility

Each side has a reservation price

Like in civil suit: expectation of winning

The reservation price is unknown

One must:

Consider non-monetary payoffs

Probabilistically determine best offer
But probability implies a chance that no
bargain will be made
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Lessons

Rules of the game uniquely

determine the bargaining outcome

Which rules are better for you

depends on patience, information

Delays are always less profitable:

Someone must be wrong
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