EC 340

Lecture 6 - Negotiating

from last time
the prisoners' dilemma
the rational pigs
negotiating with a deadline
what are the sources of bargaining strength?
using information strategically
overcoming an informational disadvantage
using an informational advantage
negotiating international trade agreements

From Last time

The Prisoners' Dilemma

A pair of transients, Al Fresco and Des Jardins, have been arrested for vagrancy. They are suspected of complicity in a robbery, but the evidence is inadequate to convict them. The DA interrogates them in separate cells and offers them each the following deal. "If you confess and your friend does not, you will be released and your friend will have the book thrown at him; and the other way around if he confesses and you do not. If both confess, both will receive moderately long sentences. If neither confesses, both will be convicted of a minor vagrancy charge." What does rationality dictate that our players do?

prisoners dilemma

Define the equilibrium as the outcome of simultaneously rational decisions by both of the players. An outcome is not efficient if there is another outcome that both players would prefer. The Prisoners' Dilemma shows that people who fail to cooperate for their own mutual benefit may be acting perfectly rationally.

The Rational Pigs

Two pigs, one dominant and the other subordinate, are put in a box. There is a lever at one end of the box which, when pressed, dispenses food at the other end. Thus the pig that presses the lever must run to the other end; by the time it gets there, the other pig has eaten most, but not all, of the food. The dominant pig is able to prevent the subordinate pig from getting any of the food when both are at the food. Assuming the pigs can reason, which pig will press the level?

rational pigs
Let's attach some numbers to the game: The subordinate pig's bet response is "don't press" so the dominant pig presses the lever. This game shows that weakness can be a strength in bargaining.

Negotiating with a Deadline

Mortimer and Hotspur are to divide $100 between themselves. Each of the bargainers knows that the game has the following structure: What will Mortimer demand at the first stage?

Mortimer must imagine the game has reached the second stage. Hotspur is now in a strong position and can demand almost all of the $90, leaving Mortimer just enough so that he doesn't say no because of spite. This game shows that the last person to make the offer can capture most of the remaining gains from trade. So, get your offer in before the deadline so that your bargaining partner has no choice but to accept it.

What are the Sources of Bargaining Strength?

What matters is each bargainer's belief about what price his opponent will find acceptable: what does each bargainer believe about the other's willingness to settle and about the others's beliefs.

  1. alternative opportunities: the more attractive a bargainer's alternative opportunities are, the better the negotiated outcome will be for that bargainer
  2. relative costs of delay: the more impatient your opponent is to settle, the better is the agreement you can hold out for
Bargaining games usually have many possible agreements that leave both bargainers better off than at the status quo. Suppose there is something about the bargaining situation that serves to highlight a particular outcome. Then we have a focal point, e.g. something highlighted by precedent, mathematical symmetry, suggested by an impartial mediator.


A commitment shapes the buyers expectations of what the seller will settle for.

ways of being inflexible during negotiations:

Using Information Strategically

Bargainers typically do not know exactly the other's valuation, alternative opportunities, costs of delay, and commitment possibilities. These are all private information.

Suppose a seller has cars for sale which cost the seller $1000 each and that there are two kinds of buyers (50 of each), one values the car at $1040 and the other, $1100 but the seller cannot distinguish between the two. The seller makes a take-it-or- leave-it offer. What price should he charge?

Private information means that some mutually beneficial sales are not made.

Private information can be a source of bargaining power, resulting in extra gains going to the holder of the information. Suppose the lower valuation is $1060, then the seller charges $1060 and the high-valuation customers get a windfall from their private information.

Overcoming an Informational Disadvantage

Screening means structuring the negotiations to induce the other party to reveal private information.

Suppose delay is costly to the buyer, e.g. second period gains are valued at 80% of first period gains. The seller can ask for a relatively high price in the first period and drop the price in the second period to $1060. Purchasing in the second period yields a high-valuation buyer (0.8)(1100-1060) = $32. So, the best first period price is $1068. Then all the high valuation buyer purchase the car in the first period yielding the seller profits of $68 a car. The price in the second period is $1060. The 50 low valuation customers purchase the car at this price. Total profits are $6400. The seller achieves higher profits with a screening strategy.

Using an Informational Advantage

Consider the market for used cars. A potential buyer cannot tell whether a used car is a good car that will run well or is a lemon that will never run right. After one has owned a car for a while, one learns something about the quality of the automobile. So, the seller knows more about the quality of a used car than the buyer.

Since the buyer cannot tell the difference between a good and a bad car, both good and bad cars must sell for the same price somewhere in between the low value of a lemon and the high value of a good car. Suppose that buyers know that 60% of used cars are lemons. A buyer is willing to pay $2000 for a good car and $1000 for a lemon. Sellers are willing to accept $1500 for a good car and $500 for a lemon. Since the price will reflect the average car quality, all used cars will sell for $1400.

Sellers of lemons are more than happy to receive a price higher than the lemon's low quality, but sellers of good cars will be unwilling to sell at a price below its high value. Therefore, only lemons will be offered for sale.

The seller of a good car must communicate information about the car's quality in a way that the buyer will believe. The seller of a good car must find a signal. A signal is an action that is more costly if you are lying than if you are telling the truth.

Negotiating International Trade Agreements

GATT (General Agreement on Tariffs and Trade) has successfully lowered tariffs but it has not removed other kinds of trade barriers such as government regulations and subsidies. The U.S. has threatened to restrict entry into the U.S. market in retaliation against nations that it perceives have unfairly closed their borders to U.S. firms if the offending barriers are not removed. What determines the success or failure of such aggressive bargaining tactics?

International trade negotiators place a positive value on their nation's trade restrictions. So, setting up trade restrictions has a Prisoners' Dilemma character with both nations imposing high tariffs.

Retaliation can be used to enforce agreement in repeated games. If one country pursues its immediate interests, departing from a pre-existing agreement to maintain low tariffs, then the other country retaliates by increasing its own tariffs. This is allowed under GATT.

GATT and the World Trade Organization serve to establish focal points, e.g. principle of reciprocity under which countries trade tariff reductions so as to achieve a perceived balance of concessions. But, nontariff barriers are more difficult to measure and there is no common definition of how to measure them. No focal points (such as equal reductions) are available. This explains GATT's inability to remove non-tariff barriers to trade.

Section 301 of the 1974 Trade Act enables the President to retaliate against foreign countries' trade-restricting policies that reduce U.S. exports. The Super 301 provision of the 1988 Omnibus Trade and Competitiveness Act strengthened the retaliatory provisions. Super 301 threatens to withhold access to the U.S. market unless our demand are met. This gives the U.S. bargaining power with countries that are very dependent on sales to us. The ability to counter-retaliate weakens U.S. bargaining power. For example, the U.S. did not put the EC on the 1989 list of "unfair" traders while India and Brazil were.

Aggressive bargaining actions are likely to be successful if they are addressed at countries

  1. with small counter-retaliation ability
  2. that would suffer significant harm from having their market access limited

David A. Latzko
318 COB
Department of Business and Economics
Wilkes University
Wilkes-Barre, PA 18766
phone: (717) 408-4718
fax: (717) 408-4917