Some people have things. Other people want them. Economists agree that the eventual price will be set by supply and demand, but both parties have tragically misplaced their copies of the Big Book Of Levels Of Supply And Demand For All Goods. They're going to have to decide on a price by themselves.
When the transaction can be modeled by the interaction of one seller and one buyer, this kind of decision usually looks like bargaining. When it's best modeled as one seller and multiple buyers (or vice versa), the decision usually looks like an auction. Many buyers and many sellers produce a marketplace, but this is complicated and we'll stick to bargains and auctions for now.
Simple bargains bear some similarity to the Ultimatum Game. Suppose an antique dealer has a table she values at $50, and I go to the antique store and fall in love with it, believing it will add $400 worth of classiness to my room. The dealer should never sell for less than $50, and I should never buy for more than $400, but any value in between would benefit both of us. More specifically, it would give us a combined $350 profit. The remaining question is how to divide that $350 pot.
If I make an offer to buy at $60, I'm proposing to split the pot "$10 for you, $340 for me". If the dealer makes a counter-offer of $225, she's offering "$175 for you, $175 for me" - or an even split.
Each round of bargaining resembles the Ultimatum Game because one player proposes to split a pot, and the other player accepts or rejects. If the other player rejects the offer (for example, the dealer refuses to sell it for $60) then the deal falls through and neither of us gets any money.
But bargaining is unlike the Ultimatum Game for several reasons. First, neither player is the designated "offer-maker"; either player may begin by making an offer. Second, the game doesn't end after one round; if the dealer rejects my offer, she can make a counter-offer of her own. Third, and maybe most important, neither player is exactly sure about the size of the pot: I don't walk in knowing that the dealer bought the table for $50, and I may not really be sure I value the table at $400.
Our intuition tells us that the fairest method is to split the profits evenly at a price of $225. This number forms a useful Schelling point (remember those?) that prevents the hassle of further bargaining.
The Art of Strategy (see the beginning of Ch. 11) includes a proof that an even split is the rational choice under certain artificial assumptions. Imagine a store selling souvenirs for the 2012 Olympics. They make $1000/day each of the sixteen days the Olympics are going on. Unfortunately, the day before the Olympics, the workers decide to strike; the store will make no money without workers, and they don't have enough time to hire scabs.
Suppose Britain has some very strange labor laws that mandate the following negotiation procedure: on each odd numbered day of the Olympics, the labor union representative will approach the boss and make an offer; the boss can either accept it or reject it. On each even numbered day, the boss makes the offer to the labor union.
So if the negotiations were to drag on to the sixteenth and last day of the Olympics, on that even-numbered day the boss would approach the labor union rep. They're both the sort of straw man rationalists who would take 99-1 splits on the Ultimatum Game, so she offers the labor union rep $1 of the $1000. Since it's the last day of the Olympics and she's a straw man rationalist, the rep accepts.
But on the fifteenth day of the Olympics, the labor union rep will approach the boss. She knows that if no deal is struck today, she'll end out with $1 and the boss will end out with $999. She has to convince the boss to accept a deal on the fifteenth day instead of waiting until the sixteenth. So she offers $1 of the profits from the fifteenth day to the boss, with the labor union keeping the rest; now their totals are $1000 for the workers, $1000 for the boss. Since $1000 is better than $999, the boss agrees to these terms and the strike is ended on the fifteenth day.
We can see by this logic that on odd numbered days the boss and workers get the same amount, and on even numbered days the boss gets more than the workers but the ratio converges to 1:1 as the length of the negotiations increase. If they were negotiating an indefinite contract, then even if the boss made the first move we might expect her to offer an even split.
So both some intuitive and some mathematical arguments lead us to converge on this idea of an even split of the sort that gives us the table for $225. But if I want to be a “hard bargainer” - the kind of person who manages to get the table for less than $225 - I have a couple of things I could try.
I could deceive the seller as to how much I valued the table. This is a pretty traditional bargaining tactic: “That old piece of junk? I'd be doing you a favor for taking it off your hands.” Here I'm implicitly claiming that the dealer must have paid less than $50, and that I would get less than $400 worth of value. If the dealer paid $20 and I'd only value it to the tune of $300, then splitting the profit evenly would mean a final price of $160. The dealer could then be expected to counter my move with his own claim as to the table's value: “$160? Do I look like I was born yesterday? This table was old in the time of the Norman Conquest! Its wood comes from a tree that grows on an enchanted island in the Freptane Sea which appears for only one day every seven years!” The final price might be determined by how plausible we each considered the other's claims.
Or I could rig the Ultimatum Game. Used car dealerships are notorious for adding on “extras” after you've agreed on a price over the phone (“Well yes, we agreed the car was $5999, but if you want a steering wheel, that costs another $200.”) Somebody (possibly an LWer?) proposed showing up to the car dealership without any cash or credit cards, just a check made out for the agreed-upon amount; the dealer now has no choice but to either take the money or forget about the whole deal. In theory, I could go to the antique dealer with a check made out for $60 and he wouldn't have a lot of options (though do remember that people usually reject ultimata of below about 70-30). The classic bargaining tactic of “I am but a poor chimney sweep with only a few dollars to my name and seven small children to feed and I could never afford a price above $60” seems closely related to this strategy.
And although we're still technically talking about transactions with only one buyer and seller, the mere threat of another seller can change the balance of power drastically. Suppose I tell the dealer I know of another dealer who sells modern art for a fixed price of $300, and that the modern art would add exactly as much classiness to my room as this antique table - that is, I only want one of the two and I'm indifferent between them. Now we're no longer talking about coming up with a price between $50 and $400 - anything over $300 and I'll reject it and go to the other guy. Now we're talking about splitting the $250 profit between $50 and $300, and if we split it evenly I should expect to pay $175.
(why not $299? After all, the dealer knows $299 is better than my other offer. Because we're still playing the Ultimatum Game, that's why. And if it was $299, then having a second option - art that I like as much as the table - would actually make my bargaining position worse - after all, I was getting it for $225 before.)
Negotiation gurus call this backup option the BATNA (“Best Alternative To Negotiated Agreement”) and consider it a useful thing to have. If only one participant in the negotiation has a BATNA greater than zero, that person is less desperate, needs the agreement less, and can hold out for a better deal - just as my $300 art allowed me to lower the asking price of the table from $225 to $175.
This “one buyer, one seller” model is artificial, but from here we can start to see how the real world existence of other buyers and sellers serve as BATNAs for both parties and how such negotiations eventually create the supply and demand of the marketplace.
The remaining case is one seller and multiple buyers (or vice versa). Here the seller's BATNA is “sell it to the other guy”, and so a successful buyer must beat the other guy's price. In practice, this takes the form of an auction (why is this different than the previous example? Partly because in the previous example, we were comparing a negotiable commodity - the table - to a fixed price commodity - the art.)
How much should you bid at an auction? In the so-called English auction (the classic auction where a crazy man stands at the front shouting “Eighty!!! Eighty!!! We have eighty!!! Do I hear eighty-five?!? Eighty-five?!? Eighty-five to the man in the straw hat!!! Do I hear ninety?!?) the answer should be pretty obvious: keep bidding infinitesmally more than the last guy until you reach your value for the product, then stop. For example, with the $400 table, keep bidding until the price approaches $400.
But what about a sealed-bid auction, where everyone hands the auctioneer their bid and the auctioneer gives the product to the highest? Or what about the so-called “Dutch auction” where the auctioneer starts high and goes lower until someone bites (“A hundred?!? Anyone for a hundred?!? No?!? Ninety-five?!? Anyone for...yes?!? Sold for ninety-five to the man in the straw hat!!!).
The rookie mistake is to bid the amount you value the product. Remember, economists define “the amount you value the product” as “the price at which you would be indifferent between having the product and just keeping the money”. If you go to an auction planning to bid your true value, you should expect to get absolutely zero benefit out of the experience. Instead, you should bid infinitesimally more than what you predict the next highest bidder will pay, as long as this is below your value.
Thus, the auction beloved by economists as perhaps the purest example of auction forms is the Vickrey, in which everyone submits a sealed bid, the highest bidder wins, and she pays the amount of the second-highest bid. This auction has a certain very elegant property, which is that here the dominant strategy is to bid your true value. Why?
Suppose you value a table at $400. If you try to game the system by bidding $350 instead of $400, you may lose out and can at best break even. Why? Because if the highest other bid was above $400, you wouldn't win the table in either case, and your ploy profits you nothing. And if the highest other bid was between $350 and $400 (let's say $375), now you lose the table and make $0 profit, as opposed to the $25 profit you would have made if you had bid your true value of $400, won, and paid the second-highest bid of $375. And if everyone else is below $350 (let's say $300) then you would have paid $300 in either case, and again your ploy profits you nothing. Bid above your true valuation (let's say $450) and you face similar consequences: either you wouldn't have gotten the table anyway, you get the table for the same amount as before, or you get the table for a value between $400 and $450 and now you're taking a loss.
In the real world, English, Dutch, sealed-bid and Vickrey auctions all differ a little in ways like how much information they give the bidders about each other, or whether people get caught up in the excitement of bidding, or what to do when you don't really know your true valuation. But in simplified rational models, they all end at an identical price: the true valuation of the second-highest bidder.
In conclusion, the gentlemanly way to bargain is to split the difference in profits between your and your partner's best alternative to an agreement, and gentlemanly auctions tend to end at the value of the second-highest participant. Some less gentlemanly alternatives are also available and will be discussed later.