Chapter 14: Negotiations Overview In a negotiation, he who cares less, wins. [1] The two of you can share a pie but only after agreeing on how to divide it. Often it’s clear that players would benefit from collaborating, but it’s not obvious how the fruits of this collaboration should be shared. Consider a simple game where a seller owns a good that is worth $1000 to him but $1300 to a buyer. Value of Good to the Buyer = $1300 Value of Good to the Seller = $1000 We can make two inferences about negotiations between these parties:  Both parties have the potential to benefit from trade.  If the buyer acquires the good, he will pay between $1000 and $1300. Parties can always benefit from trade when a potential buyer values the good more than the potential seller does. Whenever you consider bargaining with someone, you should first identify whether there are any possible gains from trade. If the good in our example was worth less than $1000 to the buyer, then the parties should not bother negotiating. Given that the buyer values the good more than the seller does, how much will it be traded for? We can’t tell without more information. We can, however, use the values the parties place on the good to determine its potential sale price range. Since neither party will agree to an arrangement that makes him worse off, the seller will never accept less than $1000, and the buyer won’t ever pay more than $1300. The amounts of $1300 and $1000 represent the buyer’s and seller’s respective walking away prices. Assuming that the two parties come to a deal, neither party will ever have to walk away. What would have happened if a party had walked away, however, is critical in determining the parties’ negotiating strength. Consequently, the party who cares least about the negotiations succeeding has an advantage, for he would be hurt less by walking away. Armies frequently launch attacks just before starting peace talks. [2] Even if both sides expect the peace talks to succeed, they still have massive incentives to carry out a successful strike before the talks to increase their negotiating strength. Similarly, even if you are certain you can negotiate some deal, you still should establish that you would do well if the deal fell through. [1] Boone (1999), 113. [2] McMillan (1992), 49. Take-It-or-Leave-It Offers What would happen in our example if the seller could make a take-it-or-leave-it offer to the buyer? If a take-it-or-leave-it offer is rejected, the game ends and the good isn’t traded. If the seller could make such an offer, he should offer to sell the product for just under $1300. Since the buyer values the good at $1300, he would be better off accepting any offer less than $1300. As this example shows, a party who can make a take-it-or- leave-it offer gets all the benefits of the trade. To make an effective take-it-or-leave-it offer, you must make credible your threat to walk away from negotiations if your initial offer is rejected. The threat to walk away, however, often lacks credibility because both parties will still benefit from further negotiations if the first offer is rejected. The best way to make credible take-it-or-leave-it offers is to establish a record of having walked away from past negotiations. “Boulwarism”is making a reasonable offer and then refusing to negotiate further. [3] The term refers to Lemuel R. Boulware, a vice president at General Electric who developed a strategy of never negotiating with unions. Boulware would make a single take-it-or-leave- it offer to workers. By developing a pattern of making such offers, Boulware’s stance gained credibility. Imagine you’re negotiating a business deal that must be concluded within the next 24 hours, and you would like to propose a take-it-or-leave-it offer. You are certain that if your prospective partner was forced to either (1) accept the offer or (2) walk away from the deal, then she would accept. Unfortunately, you suspect that your prospective partner will respond to your offer with a somewhat less favorable counteroffer. You can make a take-it-or-leave-it offer only if you can credibly threaten never to consider any other offers if yours is rejected. If your prospective partner believes that you really want the deal to succeed, then she will also know that you would be unwilling to walk away from her counteroffer. You could greatly improve your negotiating position by eliminating the possibility of your ever hearing her counterproposal. You could, for example, mail her an offer and then leave town for a vacation. By reducing your options. you would be reducing hers. If you could not respond to a counteroffer, then your potential partner would either have to either accept your offer or walk away. [3] Ibid., 56. Bring Another Party to the Negotiations Let's go back to our simple negotiating game between the buyer and seller. Assume that now, however, there exists a second buyer who also values the good at $1300. Further assume that the two buyers won't collude but rather will compete to buy the good from the seller. Value of the Good to Buyer 1 = $1300 Value of the Good to Buyer 2 = $1300 Value of the Good to the Seller = $1000 When we add a second seller, we can determine the exact sale price. Would it be reasonable for buyer 1 to acquire the good for $1200? No, because this outcome is not stable since buyer 2 would be willing to pay more than $1200 for the item. Thus, if the two buyers compete, buyer 2 would never allow buyer 1 to acquire the good for only $1200. Imagine that the three people are in a room negotiating. The negotiations couldn't end with the seller agreeing to give the good to buyer 1 for $1200 because buyer 2 would offer to pay $1201 before he would ever leave the room empty-handed. The only stable outcome in our three-person game is for the good to be sold for $1300. The existence of the second buyer gives the seller all the potential profits from trade. Both sellers need the buyer, whereas the buyer needs only one seller. Consequently, if the seller can get the buyers to compete against each other, he can drive down their profits to zero. Of course, if the buyers don't compete, then they would do much better. Let's slightly change the game and assume that buyer 2 values the good at only $1250. Value of the Good to Buyer 1 = $1300 Value of the Good to Buyer 2 = $1250 Value of the Good to the Seller = $1000 In this game buyer 1 will end up with the good because she would always outbid buyer 2. The sale price will fall between $1250 and $1300. It's not a stable outcome for the good to be sold for, say, $1230 because the buyer who didn't get the product would have been willing to outbid her rival. It is stable for the good to be sold for somewhere between $1250 and $1300 to buyer 1 because then buyer 2 wouldn't benefit from making a higher counteroffer. Imagine that you are the seller and you get a call from buyer 2 just a day before the start of negotiations. Buyer 2 says that he isn't going to bother showing up since he knows he will eventually be outbid by buyer 1. It's entirely rational for buyer 2 to stay home and not waste his time in fruitless negotiations he is destined to lose. As the seller, however, you should be horrified by the prospect of buyer 2 staying home. Without buyer 2, the price will be somewhere between $1000 and $1300. With him, the range contracts to between $1250 and $1300. Consequently, the seller should beg buyer 2 to show up, bribing him if necessary. [4] Of course, buyer 1 should also be willing to bribe buyer 2 not to show. Therefore, even though buyer 2 won't end up purchasing the good, he could still profit from the negotiations. In his negotiations with CBS, David Letterman exploited the tactic of increasing the number of buyers. David Letterman hosts a late night comedy show for CBS, and his contract was about to expire. CBS, reportedly, told the talk show host that he had no other place to take his show if he didn't renew with CBS. David Letterman's show plays best from about 11:30 to 12:30 p.m., during which time NBC runs the popular Tonight Show and ABC runs the highly respected Nightline. ABC, however, indicated that it would consider dumping Nightline and running Letterman's show instead. Although Letterman ultimately renewed his contract with CBS, getting ABC to express interest in him no doubt strengthened his bargaining position. [4] Brandenburger and Nalebuff (1996), 83-85. Giving Up Control Giving up control can also increase your negotiating strength. [5] If you prove that you are not authorized to pay more than a certain amount, you may favorably contract the sale price range. In our first example, Value of Good to the Buyer = $1300 Value of Good to the Seller = $1000 The seller would benefit by, say, convincing the buyer that she couldn’t sell the item for less than $1250. Of course, the buyer might suspect that the seller is lying to increase her negotiating strength. Giving up control to an agent who has a different objective than you can often enhance your negotiating position. [6] Imagine that in the above game the buyer hires a professional negotiator who has a reputation for either getting a great deal or walking away from the negotiations. Although the buyer would be better off paying $1250 than not getting the good, the agent would prefer to terminate negotiations than ruin his reputation by getting a poor deal. If the seller knows about the agent’s reputation, then the possible price range should shift in the buyer’s favor. [5] See McMillan (1992), 55. [6] Schelling (1960), 29. Brinksmanship [7] A willingness to go to the brink may also strengthen your negotiating position. Brinksmanship is best understood in the context of war. India and Pakistan have long been enemies. India is much larger than Pakistan and has a superior conventional army. In a conventional war between these rivals, India would almost certainly win. A war between these nations might not stay conventional, however, for Pakistan and India each have atomic weapons. Since both India and Pakistan would be devastated by an atomic war, how much protection does Pakistan get from its own atomic weapons? A threat by Pakistan to attack India with atomic weapons if India invaded would not be credible because India would surely respond in kind to any atomic aggression. Pakistan would clearly be better off conquered by India’s army than decimated by its atomic weapons. Consequently, a rational Pakistan would never deliberately use atomic weapons if it thought that India wasn’t going to use them. Therefore, India would not believe that Pakistan would deliberately use atomic weapons in response to a purely conventional attack. So, how can Pakistan make its threat to use atomic weapons more credible? Perhaps it could have loose control over its weapons. Pakistan could give control of each nuclear missile to a different general and put the missiles near the Indian border. Now, imagine that India attacks and its troops fire directly on a general who has control of an atomic weapon. Even if his leaders didn’t want him to push the button, the general, who might be facing imminent death, would be tempted to use the atomics anyway. By having weak control over its nuclear missiles, Pakistan would be employing brinksmanship. Brinksmanship means deliberately taking a crisis to the brink of disaster. If Pakistan had limited control over its nuclear missiles, then any conventional war between Pakistan and India would risk becoming an atomic catastrophe. Brinksmanship makes a threat far more credible, because when you are at the brink mistakes might occur. By practicing nuclear brinksmanship, Pakistan could use its atomic weapons to effectively deter India’s conventional army even if India assumes that Pakistan would never deliberately use atomics. Businesspeople, as well as military planners, can benefit from using brinksmanship. For example, a party to a labor negotiation might create the risk of an “unwanted” strike to increase his bargaining position. [8] Imagine that a union contract is about to expire, and it would be devastating to both the company and union to not have a new contract. The union, however, wants to threaten the company with a work stoppage. This threat normally would lack credibility because a strike would harm the union. The union could, however, use brinksmanship to enhance the threat’s credibility. For example, the union could wait until the last minute to negotiate the contract so that failure might automatically result in a strike. The union could also openly condemn management so that its workers might vote against an unfavorable contract even if the union’s leadership wanted to avoid a strike. [9] This tactic would combine giving up control with brinksmanship. By deliberately making it difficult to accept a new contract, the union could enhance its negotiating position by credibly signaling that it couldn’t accept a new agreement that didn’t significantly increase employees’ salaries. [7] See Dixit and Nalebuff (1991), 292–295. [8] Ibid., 293–294. [9] Schelling (1960), 27. Goals of Negotiations When you are about to commence negotiations, always determine what you and your potential partner would get if negotiations fail, for this determines the possible range of settlement. During negotiations, consider what credible threats you could execute to improve this range in your favor. Auctions In this chapter buyers and sellers engaged in unstructured negotiations. Chapter 15 explores a highly formal method by which to sell goods: auctions. Lessons Learned  What you would get if negotiations fail often determines what you do get if negotiations succeed.  A party who can make a take-it-or-leave-it offer can get the entire surplus from a transaction.  Bringing other parties to your negotiations can radically alter the bargaining environment.  Giving up control can enhance your negotiating position.  Taking negotiations to the brink of failure can make credible a threat to do something that is not in your self-interest. Chapter 15: Auctions Overview Be not too hasty to outbid another. Proverb [1] While auctions have always interested game theorists, the Internet has recently made them relevant to more ordinary mortals. Indeed, the on-line auction provider eBay has be-come one of the few profitable pure Internet companies. Auctions reduce the cost of ignorance. A seller unaware of how much customers value his good normally faces a dilemma: He can set a high price and risk his good going unpurchased, or set a low price and, alas, get low prices. When auctioning goods, however, the seller need not determine the optimal price, because in auctions the price of goods automatically changes in response to buyer demand. Auctions are especially valuable to sellers of time-limited products like airline seats and hotel rooms. If you sell durable goods and set too high a price, you always have time to resell the items. If, instead, you sell a time-limited product but find no buyers, then the item is forever lost. Since auction prices will automatically be reduced until the market clears, auctions almost never leave you with unsold merchandise. The two most common types of auctions are first price sealed-bid auctions and second price sealed-bid auctions. [1] Browning (1989), 360. . 27. Goals of Negotiations When you are about to commence negotiations, always determine what you and your potential partner would get if negotiations fail,. away from the negotiations. Although the buyer would be better off paying $1250 than not getting the good, the agent would prefer to terminate negotiations