How can game theory help in negotiations?

Everybody negotiates. Some people like it, others hate it but all agree that the ability to negotiate well is a valuable business skill and therefore it’s something worth doing well. To be successful in negotiations, you have to be tough, but it also helps to have a strategy. Fortunately, Game Theory provides us with insights that can lead to practical results.

The Simplest Game: Two Person with a Fixed Pie

Usually when we think of negotiations, we imagine two people facing off against each other. Whatever one wins, the other loses. These were the first type of games that Game Theory attempted to solve, so it’s a good place to get started.

Look at the following example where Neil owes Bob some money and they have to agree on how much. They each have two strategies available to them, but the outcome is not just dependent on the strategy chosen, but also on what their opponent does. So while Neil would obviously choose to pay the minimum (4) and Bob would like to have the maximum (6) the opposing move needs to be taken into account before an optimal strategy can be selected.

Neil-Pays-Bob-2-Strategies.png

This is about the simplest game imaginable, so you don’t have to be a game theorist to figure out that the payoff will most likely be 5, but it illustrates a very good rule called the minimax theorem. The concept, which was originated by the legendary John von Neumann, simply says that you should pick the strategy where the maximum advantage of your opponent is minimized.

In the above example, Neil would pick strategy #2 to avoid the possibility of having to pay 6 while Bob would pick strategy #1 to avoid only getting paid 4.

Minimax is a simple but useful rule that can be applied to everyday situations. However, it’s problematic partly because it assumes perfect information. In the real world, things are much more confusing, not least because our negotiating opponent is rarely limited to two strategies.

Let’s see what happens if we add additional strategic possibilities.

2-person-zero-sum-2-1024x811.png

Mathematically, the game is still solvable, but you can see that it gets much more complicated just by adding a few extra strategic choices. Therefore, it is generally an advantage to have less options for yourself and more options for your opponent (although a bit counter-intuitive).

Game theorists achieve this mathematically by determining which strategies are numerically dominant and using randomly mixed strategies. In real life, you just need to have a clear idea of what you want and eliminate inferior options. Your advantage can sometimes be increased if you don’t announce your preferences to your opponent so that he still has to consider variables which you don’t.

Reducing variables for yourself is almost always a good idea. Ironically, someone with a gun to his head is in a very strong negotiating position (with people other than the gunman of course) because he has few choices . In the world of business, we usually refer to a boss or shareholders in order to show that our options are limited, but the principle is the same.

In reality negotiations have many complications. For instance, it makes a big difference if one player chooses first, whether they play one time or if it’s an ongoing game, whether there are side deals, etc.nOne particularly interesting real world difficulty that we’ll discuss next is that we often find that some agreements seem to be in place even before we start negotiating!

When you negotiate internationally, you often hear the phrase “everybody knows that it works this way.” This can be very frustrating; not least because it so often follows you saying “that’s the craziest thing I’ve ever heard!”

This phenomenon is a result of “tacit bargaining,” a term first coined by Thomas Schelling (he later won the Nobel Prize for his work). It’s more common than you would think. Consider the following experimental results cited by Schelling:

  • When asked to pick any number, 40% chose the number 1.
  • The overwhelming majority of people chose heads over tails on a coin toss
  • When asked to pick any amount of money almost all people chose a figure divisible by 10
  • When people where told that they had to meet someone else – but had to guess the time – almost all chose noon.
  • An overwhelming majority of people would rather pay dues than taxes
  • We often concede to convention without even knowing it (although it becomes much more apparent when we encounter customs we’re not used to). It is natural for us to want to abide by notions of fairness and precedence. Nobody likes to be seen as rocking the boat.

Therefore, it is generally an advantage to make the first move in a negotiation, even though most people are reticent to do so. Making the first proposal gives you the opportunity to frame the negotiation and establish precedence. Another insight gained from research into tacit bargaining is that often an outsider can be more effective. That’s why when you start getting comfortable with a car salesman you inevitably end up in the manager’s office to close the deal.

Zero sum negotiations are actually quite rare. We usually enter negotiations because we expect the results to enlarge the total pie and make both sides better off. In effect, we prevail with a mixture of cooperation and competition andwe will have to make commitments in the form of promises and threats.

While we all value freedom, in negotiations the commitments we make can be extremely valuable, if they’re credible. Since they limit our options, it often takes some effort to get our negotiating partner to believe in us. Contrary to the stereotype, the last thing a good negotiator wants is to be seen as is “slick.”

Prisoner’s Dilemma

The most famous and interesting example in Game Theory is the Prisoners Dilemma.

Prisoners-Dilemma-300x283.png

The basic narrative should be familiar to anyone who’s watched a cop show. Two suspects are brought in and interrogated separately.,If they effectively cooperate with each other they will get off on a lesser charge and serve only two years. If one defects, he will only get one year in prison while his friend gets a harsh five year sentence. If they both defect, they will each get three years.

While they would both obviously benefit from keeping their mouths shut, individually the dominant strategy is to talk. By confessing, each will be better off no matter what the other one does and by holding out each will be worse off.

This is an example of the Nash equilibrium made famous in the movie A Beautiful Mind and shows how sometimes a stable solution can also be a bad one. In effect, everybody can agree to be worse off.

Of course, many games involve more than two people and most negotiations take place in a larger context. A salary negotiation will ultimately affect other salaries in the same company, a price negotiation will have ripple effects for an industry, etc.

While it’s important to remember that Game Theory consists of sanitized models with often unrealistic assumptions, we can derive some useful principles that can improve results in real world negotiations:

  • Minimize Risk: As the minimax theorum shows, all things being equal it is usually a good strategy to minimize your opponents maximum payout, even if that means that you are guaranteeing him a higher minimum.
  • Make the first offer: Unless you are at a demonstrable informational disadvantage, it is better to go first. This allows you to frame the negotiation to your advantage. Although it’s against most people’s natural inclination, the evidence is pretty strong here.
  • Beware of Precedence: While it’s difficult to go against convention, there is no reason to simply accept a situation where you are at a disadvantage.
  • Trust: The ability to make commitments such as promises and threats can be extremely valuable. If you lack credibility, you lose that capacity. Sometimes it’s better to incur a cost rather than lose stature.
  • Continuity: Open ended commitments encourage reliability while short term relationships abet duplicity. That’s why all tourists are suckers.
  • Reciprocity: Rapoport’s “Tit for Tat” strategy and subsequent evidence shows that you can expect to get what you give. Moreover, while there is no reason to set out on a nasty path, sometimes that’s where you’ll have to end up. As the Al Capone character in The Untouchables said “You get more with a kind word…and a gun, than you do with just a kind word.

Try to apply it when you get a chance.


Interesting reads:

https://www.investopedia.com/terms/g/gametheory.asp

http://bigthink.com/videos/kevin-zollman-how-to-solve-tough-negotiations-with-game-theory

http://www.economist.com/node/21527025

http://www.businessinsider.com/how-to-use-game-theory-to-your-benefit-2012-4/?IR=T

https://www.digitaltonto.com/2009/game-theory-guide-to-negotiations/

https://news.thomasnet.com/imt/2013/08/13/how-game-theory-can-help-businesses-improve-negotiations

http://www.bbc.com/news/magazine-31503875

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7 thoughts on “How can game theory help in negotiations?

  1. Thank you for summarizing and writing this post. I have always wanted to learn about game theory but hadn’t invested the time to research it. I believe mostly anything is negotiable and love the art and skill it takes to negotiate. This is great!:)

    Liked by 2 people

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