Changing Negotiations

1
Changing Negotiations

• The effect of pre-emptive commitments on later
  negotiations

2
Cooperation vs Competition

• Your payoff or profits depend ultimately on your
  added value
• At the time of negotiations, your added value is
  fixed
• But can you take unilateral (non-cooperative)
  actions prior to negotiations to improve your
  added value?

3
Actions that Change Added Value

• Improving total value
• Reducing own costs
• Improving product quality
• Network effects

• Limiting others added values
• Creating scarcity
• Encouraging competition
• Raising rivals costs

• Caveat avoid sunk expenditures prior to
  negotiations that harm relative added value
• Can lead to the hold-up problem
• Better to contract prior to sinking costs

4
Case

• Nintendo

5
Some Surprising Facts ...

• 1991 Average Market Value
• Nissan 2.0 Trillion Yen
• Sony 2.2 Trillion Yen
• Nintendo 2.4 Trillion Yen
• Why is this so?
• Added value ...

6
Nintendos Strategy The Good

• Increase total value
• Bargain hardware
• Great software (games)
• revitalised the video game business (which had
  died after Atari)
• created a virtuous cycle increased sales lead to
  more software house lining up to be part of
  Nintendo.
• Exclusivity clause in licensing agreement
• increased demand drives down manufacturing costs
• growing base of machines attracts more outside
  game developers
• increases demand further exploiting network
  effects

7
Nintendos Strategy The Bad

• Limit added value of others
• Restricting supply
• As demand increased Nintendo was careful about
  flooding the market.
• Controlled the number of copies of games produced
  and retailed
• 1988 Christmas season saw a massive shortfall in
  supply
• paradoxically, the shortfall lead to increased
  demand. Why?
• Raising rivals costs hard to replicate platform
• software prevented by exclusivity
• hardware leapfrog Nintendo with new technology
• Other players
• Combat buying power of retailers by keeping
  cartridges in short supply.
• Software security chip allowed them to manage
  licensing restrict to 5 titles develop games
  in-house and by multiple independents.
• Suppliers Mario was a hit and reduced the power
  of Mickey Mouse.

8
Nintendos Strategy The Result

• Nintendo had rebuilt home video games to a 5
  billion worldwide business
• 90 share of US and Japanese 8-bit video game
  market
• Nintendo products accounted for over 20 of the
  entire US toy industry
• Mario was more popular than Mickey Mouse with US
  children

9
Bargaining Outcomes

• What factors determine what you get from
  bargaining?
• The total payoff to the group from cooperating
• Outside options
• the payoff each player would get from going off
  on her own (i.e. her BATNA)
• the payoff each group would get from going off on
  its own ( the determinant of Added Value)
• Main question
• Can you take action to affect these payoffs?

10
Game leading up to Bargaining

• View the process of reaching agreement through
  bargaining as part of a bigger game
• Actions change surplus ultimate payoffs
• ? Need to use rollback to choose our
  pre-bargaining actions.

Player 2 makes investments
Payoffs
Bargaining
Bargaining
Payoffs
Player 1 enters the market
Bargaining
Payoffs
Other actions, payoffs
11
2-person bargaining games

• Lets look at this issue using 2-person games,
  which are simpler.
• In 2-person games there are only 3 factors that
  determine the outcome of bargaining
• The total payoff to you and the other person from
  cooperating
• Your BATNA
• The other persons BATNA

12

• Total surplus a brief reminder

• The red circle is the total payoff to both from
  cooperating
• The blue slice is the other persons BATNA
• The green slice is your BATNA

13
BATNAs and splitting the surplus

• Your payoff from bargaining is
• Your BATNA a half share of the Total
  Surplus
• the green slice ½(the red area on this
  circle)

14

• Your payoff improves when

• Increase the total payoff to both from
  cooperating ( the whole circle)
• Decrease the payoff the other has without you
  (the blue slice) reduce
  their BATNA
• Increase the payoff you have without the others
  (the green slice)
• improve your BATNA

15
Simple Example

• Your plant sells specialised rubber soles to Nike
• If you can interest Reebok in your product, your
  outside option is higher, even if Reeboks WTP is
  not as high as Nikes.
• Your BATNA has improved
• Your bargained price with Nike will increase.
• You still sell to Nike
• ? no change in total payoff, except that
  possibly it was costly to interest Reebok in your
  product
• ? total payoff may actually be lower.

16
Inefficiency and Bargaining

• We have said that the bargaining process is
  generally efficient
• Negotiators agree on the surplus-maximising
  actions.
• Then they negotiate over how to divide the
  surplus.
• BUT Actions taken before negotiating may not be
  efficient.
• You take actions to affect your BATNA and the
  other persons BATNA, even though that doesnt
  create any more total payoff.
• You are more concerned with improving your BATNA
  than with creating more total payoff!

17
Inefficiency and bargaining

• Your payoff from bargaining is
• Your BATNA a half share of the Total
  Surplus
• the green slice ½(the red slice of the
  circle)
• Before bargaining
• If you invest to increase the total payoff (
  size of the circle), you get 50 of the increase
• Insufficient incentive to increase total payoff
• If you invest to increase your BATNA, without
  changing to total payoff, you get 100 of that
  increase, as opposed to 50 before
• If you invest to decrease the other persons
  BATNA, you get 50 of that decrease!
• Excessive incentive to affect BATNAs

18
More Subtle ExampleToo smart for your own good?

• A software company is developing a game for the
  Sony Playstation.
• After developing the game, he will sell it to
  Sony, to be packaged with the Playstation
• Designing the game costs 300,000 in wages. The
  game will earn 500,000 in revenues (and there
  are no other costs to marketing it). Sony
  designed their platform so that the game cannot
  be adapted to another gaming machine (such as the
  X-Box) ? The designer has low outside options.
• Is total surplus maximised by developing the
  game?
• What is the negotiated price, if the developer
  designs the game?
• Would he agree to design?

19
Too smart for your own good?

• Sony has too good a bargaining position

(-50,000 250,000)
Split the range
Sony
design
be fair
(100,000 100,000)
Software Firm
Dont design
(0, 0)
20
Bargaining and Sunk Costs

• Why is the software design firm in such a bad
  bargaining position? SUNK COSTS
• Software firm has already incurred the costs of
  designing the game.
• ? These costs are sunk.
• The software firms outside option is zero (not
  counting sunk design costs) low outside options.

21
Specialised versus General Investments

• There are many investments that can be made to
  increase value between supplier and firm
• locating near each other
• systems to coordinate product, reduce stocks
• adapting suppliers product to work well in the
  customer firms product. Example software
  bundled with Windows
• adapting product characteristics to improve WTP
  for the overall product. Example
  extra-high-performance brakes for Mercedes.
• But if the specialized investment is not as
  valuable to other trade partners, the suppliers
  outside options are low
• the supplier is at risk of hold-up.

22
Contracts and hold-up

• If the Software firm agrees to work, it will be
  held up gain Negative Surplus from its
  investment
• A strategically-thinking firm does not agree to
  design the game, and therefore both receive a
  payoff of 0.
• This is the ultimate inefficiency no production
  takes place at all!
• The hold-up problem would be resolved if they
  could negotiate and sign a contract before the
  designer starts working but to do so, they need
  to be able to write a credible contract.
• they need a credible commitment

23
Solution Negotiate before design

• Sony and the software firm add a new option to
  the tree

(100,000 100,000)
Bargain before design
(-50,000 250,000)
Sony
Split the range
Be fair
Software Firm
(100,000 100,000)
Dont agree to design
(0, 0)
24
More general point the timing of bargaining

• In the software designers case, the contract
  needs to be written before investment to avoid
  inefficiency.
• Remember, bargaining is efficient
• If they can bargain before investing, the
  investments they make will maximise total payoff.
• The sooner we can bargain and write a contract,
  the more total payoff is saved.
• What prevents us from writing contracts early?
• you may not know who to negotiate with,
  yet Laundry business built up in a neighborhood,
  then a factory moves in afterward
• In RD you might want to sell your idea, but
  explaining your idea gives it away. ? Cant
  bargain until you patent.

25
Enforceable contracts

• Even if we bargain and write a contract, the
  contract may not be enforceable
• its difficult/expensive to verify and enforce
  injured firms wont go to court after a breach of
  contract if doing so costs more than the award
• ? in that case, its not an enforceable
  contract.
• uncertainty about the future ?hard to write
  long-term contracts.
• business is complex ? hard to spell out all the
  details.
• If a contract cant be enforced, theres no point
  in writing it.
• ? then we bargain later in the game.

26
Other solutions to the hold-up problem

• Making contracts more enforceable
• Reducing the legal cost of enforcing a contract
  
• ex arbitration is usually quicker and less
  expensive.
• Raising penalties for breach of contract.
• ex blackballing from the business community
• Building a reputation ( committing not to breach
  a contract).
• If we still cant write an enforceable contract,
  we have to find another way to commit not to hold
  up our trading partner
• Paying in installments
• Taking hostages (the Ugly Princess problem)

27
GM-Fisher Body

• 1920s General Motors purchased car bodies from
  independent firm (Fisher Body)
• Technology change wooden to metal
• GM built a new assembly plant that required
  reliable supply
• wanted Fisher Body to build a new car body plant
  next to it
• no need for shipping docks etc.

28
Fisher Refused

• Fisher Body refused to make this investment.
• Feared that a plant so closely tailored to GMs
  needs would be vulnerable to GMs demands
  (hold-up)
• Eventually resolved this issue by vertical
  integration -- could not find a contractual
  solution

29
Merger Benefits Costs

• Benefits to GM
• Could make more demands of Fisher Body
• More investment or extra supply
• Costs to GM
• Diminished managerial incentives
• If costs are lowered in the body plant, GM is
  better able to appropriate these at expense of
  managers.
• Harder to keep those costs down.

30
Connection to multi-person games

• A monopoly has an incentive to commit to restrict
  supply.
• Why? It reduces the total payoff
• But it limits the Added Value of each buyer
• Actions taken before bargaining can affect the
  bargaining outcomes
• Once again, you can be too smart for your own
  good
• If buyers have to make sunk investments to be in
  the market, the monopolist has to commit not to
  hold up buyers,
• Otherwise, there will be no buyers in the market.