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Changing Negotiations. The effect of pre-emptive commitments on later negotiations. Cooperation vs Competition. Your payoff or profits depend ultimately on your added value At the time of negotiations, your added value is fixed

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Changing Negotiations

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Changing negotiations l.jpg

Changing Negotiations

The effect of pre-emptive commitments on later negotiations


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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?


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Improving total value

Reducing own costs

Improving product quality

Network effects

Limiting others’ added values

Creating scarcity

Encouraging competition

Raising rivals’ costs

Actions that Change Added Value

  • 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


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Case

Nintendo


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Some Surprising Facts ...

  • 1991 Average Market Value

    Nissan2.0 Trillion Yen

    Sony2.2 Trillion Yen

    Nintendo2.4 Trillion Yen

  • Why is this so?

    Added value ...


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Nintendo’s 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


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Nintendo’s 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.


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Nintendo’s 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


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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?


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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


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2-person bargaining games

Let’s 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 person’s BATNA


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Total surplus: a brief reminder

  • The red circle is the total payoff to both from cooperating

  • The blue slice is the other person’s BATNA

  • The green slice is your BATNA


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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)


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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


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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 Reebok’s WTP is not as high as Nike’s.

  • 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.


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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 person’s BATNA, even though that doesn’t create any more total payoff.

    • You are more concerned with improving your BATNA than with creating more total payoff!


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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 person’s BATNA, you get 50% of that decrease!

  • Excessive incentive to affect BATNAs


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More Subtle Example:Too 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?


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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

Don’t design

(0, 0)


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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 firm’s outside option is zero (not counting sunk design costs) = low outside options.


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Specialised versus GeneralInvestments

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 supplier’s product to work well in the customer firm’s 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 supplier’s outside options are low

  • the supplier is at risk of hold-up.


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    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


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    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)

    Don’t agree

    to design

    (0, 0)


    More general point the timing of bargaining l.jpg

    More general point: the timing of bargaining

    • In the software designer’s 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 R&D: you might want to sell your idea, but explaining your idea gives it away.  Can’t bargain until you patent.


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    Enforceable contracts

    Even if we bargain and write a contract, the contract may not be enforceable:

    • it’s difficult/expensive to verify and enforce: injured firms won’t go to court after a breach of contract if doing so costs more than the award

       in that case, it’s 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 can’t be enforced, there’s no point in writing it.

       then we bargain later in the game.


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    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 can’t 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)


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    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.


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    Fisher Refused

    • Fisher Body refused to make this investment.

    • Feared that a plant so closely tailored to GM’s needs would be vulnerable to GM’s demands (hold-up)

    • Eventually resolved this issue by vertical integration -- could not find a contractual solution


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    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.


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    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 tohold up buyers,

    • Otherwise, there will be no buyers in the market.


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