Bargaining Theory Explained

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Bargaining. Haggling. It is the process of completing a transaction based on a negotiated outcome instead of an outcome that is driven by market forces. Instead of having “perfect competition,” bargaining theory has two or more individuals trying to reach an agreement on any type of transaction so that both parties come away from the process in an advantageous position.

For bargaining to be an effective economic model, however, there must be knowledge and wisdom on all sides involved. If a buyer is uninformed about the product or a seller is unaware of an item’s value, then bargaining can create a transaction that would leave one party in a worse position than if the outcome was based on market forces.

When included with game theories, bargaining can be used for wage negotiations, resource distribution, or even a disarmament treaty between nations.

How Is Bargaining Theory Included in Game Theory?

A “bargaining game” is a situation where two or more entities must reach an agreement. Objects or items of value, such as currency, must be distributed. Each entity involved in the process prefers to reach an agreement instead of trying to do things on their own. Each entity also wants the outcome to favor their interests more than it favors the interests of the others who are involved in the negotiation process.

Take the example of a union negotiating a collective bargaining agreement with an employer. The workers within that union would want to maximize their wages and benefits, protecting their rights to the greatest extent possible. The employer would want to minimize the cost of wages and benefits paid to employees, protecting their rights to the greatest extent possible at the same time.

For an agreement to be reached, a compromise must be obtained. Both parties must be willing to move from their “perfect” outcome to reach an outcome that meets some, but not all, of their needs. This allows both to walk away from the negotiation feeling like they could accomplish something and be better off tomorrow than they were today.

Although multiple people may be involved in a negotiation, many bargaining situations involve just two entities. That’s why the Nash bargaining solution is such an important component of the modern bargaining theory.

What Is the Nash Bargaining Solution?

In this example, there are two entities which both want to have some portion of a specific commodity or item of value. According to Nash, this would usually involve some form of currency. The item of value is available in a limited supply.

If the total amount that both entities have requested comes to an amount that is less than what the availability happens to be, then both requests will be fulfilled. Each entity would have their exact demands met.

Should the request be greater than what is available, then neither entity would get their request. They would be required to negotiate with one another to distribute the available resources since the total pool of resources cannot meet their complete needs. Because there is no equilibrium with uncertainty, the outcome depends on the willingness to compromise and the skills of negotiation for each entity.

If there is no willingness, then bargaining theory reaches a disagreement point.

What Is the Disagreement Point in Bargaining Theory?

The disagreement point in a negotiation is reached when there is an expectation that the process could break down or stop. If one entity feels like they are not receiving something of value from the process, then it is better for them to break off the negotiation rather than continue with it. If a disagreement point is pre-determined, it can be recognized when it is reached, and this can protect the individual interests of an entity.

Increasing a personal disagreement point during the process of negotiation can also be advantageous to the party doing so. Not only does it damage the disagreement points of the other entities involved, it can improve the outcome for the entity because the threat of leaving does harm to those who wish to see an outcome achieved.

Bargaining theory allows for greater profitability and standing for every entity that is involved in a transaction. When there is knowledge behind the negotiation process, then every entity can walk away from a transaction feeling like they profited from the experience. If not, then one entity may be able to take advantage of the others to increase their profits, but the transaction will still be completed.