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. 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

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. 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

7. 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.

8. 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

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 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

12. 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

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 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.

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 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!

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 person’s BATNA, you get 50% of that decrease! • Excessive incentive to affect BATNAs

18. 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?

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

21. 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.

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) Don’t agree to design (0, 0)

24. 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.

25. 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.

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 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)

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 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

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