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LECTURE 5 SEQUENTIAL GAMES: EMPIRICAL EVIDENCE AND BARGAINING

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Introduction Sequential games require players to look forward and reason backward  SPE Order of play matters. First-mover advantage: Stackelberg game, Entry game. Strategic moves may be used to obtain an advantageous position  credibility problem Outline: Empirical evidence on how individuals play sequential games Application to bargaining

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Game complexity Games differ with respect to their complexity very simple: Stackelberg. moderately complex: connect four very complex: chess Chess problem with backward induction: game tree way too large, even for computers. first two moves: 20×20 = 400 possible games.

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Game complexity Number of board positions in Chess: app. = 10,000,000,000,000,000,000,000,000,000,000,000,000,000000,000,000 Sequential games can be incredibly complex, and backward induction may not be feasible What about less complex games? do players use backward induction? if not, what rules do they use?

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Centipede game Each node a player can take (T) or pass (P) Pass: let the other player move, the pie gets bigger Take: take 80% of the growing pie SPE: Using rollback: Player 1 chooses T in the last period... player 1 plays T in period 1

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Centipede game In a six-move centipede game played with students, economist McKelvey found that: 0% choose take at the first node (theory predicts 100%) 6% choose take at the second node 18% choose take at the third node 43% choose take at the fourth node 75% choose take at the fifth node Players rarely take in early nodes, and the likelihood of Take increases at each node SPE is inconsistent with the way people behave in (complicated) games.

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Centipede game What does it tell us about players’ rationality? Limited ability to use rollback over many steps People only think a few steps ahead  not fully rational! Explains why Probability(Take) increases as the end of the game approaches. Alternatively, players may be rational and believe that the other players are not rational If a player believes that the other player will choose “Pass”, it is his best interest to also choose “Pass” this period. Maybe players have developed a mutual understanding that neither of them will choose Take too soon.

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Centipede game Discussion Players use rules of thumb that work well in certain situations. I pass as long as the other player passes. As we get close the end of the game, I may choose Take. This rule of thumb contributes to higher payoffs Backward induction is used to some extent, but not to the extent predicted by game theory.

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BARGAINING GAMES An Application of Sequential Move Games

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What is bargaining? Economic markets Many buyers & many sellers  traditional market Many buyers & one seller  auction One buyer & one seller  bargaining Bargaining problems arise when the size of the market is small. There are no obvious price standards because the good is unique. Foundations of bargaining theory: John NASH: The bargaining problem. Econometrica, 1950.

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What is bargaining? A seller and a buyer bargain over the price of a house Labor unions and manager bargain over wages

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What is bargaining? The “Bargaining Problem” arises in economic situations where there are gains from trade The problem is how to divide the gains (or surplus) generated from trade. E.g. the buyer values the good higher than the seller. The gains from trade are represented by a sum of money, v, that is “on the table.” Players move sequentially, making alternating offers.

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Ultimatum games 2 players. Divide a sum of money of v=1. Player 1 proposes a division. for player 1 and for player 2, such that x+y=1. Player 2: accept or reject Player 1’s proposal. If Player 2 accepts, the proposal is implemented. If he rejects, both receive 0.

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Ultimatum games Backward induction Player 2 receives 0 if he rejects. Player 2 will accept any amount y>0 Player 1 will keep “almost all”, and player 2 accepts the offer. SPE: x=1; y=0. (first-mover advantage) Second-hand car example Buyer is willing to pay up to $10,500. Seller will not sell for less than $10,000. (v=$500) The seller knows the buyer will accept any price p

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Alternating Offers (2 rounds) Take-it-or-leave-it games are too trivial; there is no back-and-forth bargaining.. If the offer is rejected, is it really believable that both players walk away? Or do they continue bargaining? Suppose that if Player 2 rejects the offer, he can make a counteroffer. If Player 1 rejects the counteroffer, both get 0.

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Alternating Offers (2 rounds) Reasoning backwards: Player 1 will accept any positive counteroffer from player 2. Player 2 will then propose to keep “almost all”. Player 1 is in no position to make an offer that player 2 will accept, unless he proposes player 2 to keep almost all. SPE: Player 2 gains (almost) the whole surplus. Lesson: Put yourself into a position to make a take-it- or leave-it offer. (last-mover advantage)

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When does it end?? Alternating offers bargaining games could continue indefinitely. In reality they do not. The gains from trade diminish in value over time, and may disappear. – e.g. Labor negotiations – Later agreements come at a price of strikes, work stoppages. The players are impatient (time is money!). If time has value, both parties would prefer to come to an agreement today rather than tomorrow.

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Impatience Suppose players value $1 now as equivalent to $1(1+r) one round later. Discount factor is δ =1/(1+r). Indeed $1/(1+r) now= $1 later, or $δ now = $1 later. If r is high, then δ is low: players discount future money amounts heavily, and are therefore very impatient. E.g. r=0.6  δ =0.62 If r is low, then δ is high; players regard future money almost the same as current amounts of money and are more patient. E.g r=0.05  δ =0.95

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Impatience Game representation:

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Alternating offers (2 rounds) with impatience In round 2, only  remains. Player 2 proposes to split  as {0, } and player 1 accepts. Player 2 obtains everything: . In round 1, players offers just enough for player 2 to accept: Player 1 offers , and keeps 1-. Thus, player 1 proposes {x, y} = {1-, }, which is accepted.

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First- or second-mover advantage? Are you better off being the first to make an offer, or the second? It depends on , ( between 0 and 1). If =0.8 SPE: {1-, }= {0.2, 0.8}.  second-mover advantage When players are slightly impatient, the second-mover is better off. Low cost for player 2 of rejecting the first offer. If =0.2 SPE: {1-, }= {0.8, 0.2}.  first-mover advantage When players are very impatient, the first-mover is better off. High cost of rejecting the first offer.

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Example: Bargaining over a House δ =0.8 There are two rounds of bargaining. The Seller has to sell by a certain date The Buyer has to start a new job and needs a house. The buyer makes a proposal first. Equilibrium: {1-, }= {0.2, 0.8}  $8,000 for the seller; $2,000 for the buyer. The sale price of the house is $150,000+$8,000=$158,000.

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Don’t Waste In reality, bargaining sometimes drags on. Why doesn’t this always happen? Reputation building: Showing toughness can help in future bargaining situations. Lack of information: Seller overestimates the buyer’s willingness to pay.

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Infinitely Repeated Analysis What if the game is repeated infinitely and players are impatient? No limit to the number of counteroffers. To solve, note that: If player 1 offer is rejected, player 2 will be in the same position player 1 faced.

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Infinitely Repeated Analysis Player 1 knows that player 2 can get share x in round 2. Thus player 1 must offer δx for player 2 to accept it. (δx today is equivalent to x tomorrow) Player 1 is left with 1- δx. But since the game is the same each round, if player 2 can get x next round, player 1 can also get x this round. Thus, x= 1- δx, or:

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Infinitely Repeated Analysis In our example of bargaining over a house, the buyer was the first to make an offer: The buyer keeps 56% of the surplus; the seller gets 44% The price of the house is $154,440 $150,000+0.44*10,000

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Unequal Discount Factors Now suppose that the two players are not equally impatient, i.e. For instance, δ is 0.9 for player 1; and 0.95 for player 2. Denote by x the amount that player 1 gets when he starts the process, and y the amount that player 2 gets when he starts the process. Player 1 knows that he must give to player 2. Thus, player 1 gets Similarly, when player 2 starts the process, we must offer , and keeps

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Unequal Discount Factors By substitution player 1 keeps: ...and offers The more impatient is a player, the less he receives in equilibrium... First-/second-mover advantage depends on the relative levels of impatience.

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Unequal Discount Factors In the Dixit and Skeath textbook (pp.710-711): It follows that:

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Outside options In some situations, a bargaining party has the option of breaking off negotiations A buyer negotiating with a seller may decide to start bargaining with another seller A firm negotiating with a union may have the option of closing down and selling its assets The outside options are called the BATNAs (best alternative to a negotiated agreement) BATNAs show what players would get if bargaining fails. The higher is a player’s outside option, the more he can claim. (“bargaining power”)

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Outside options Strategic moves to manipulate BATNAs A player can try to improve his BATNA to be stronger in the bargaining. For instance, before asking for a raise, try to get an offer from another employer. Your BATNA is higher, and your employer may not be in a position to refuse. A player can also try to reduce the BATNA of the other player. If you want to ask for a raise, make yourself indispensable. The employer would lose if you leave. A final option is to lower both players’ BATNAs, but decrease it more for the other player. “This will hurt you more than it hurts me”.

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Practical Lessons I In reality, bargainers do not know one another’s levels of patience or BATNAs, but may try to guess these values. Signal that you are patient, even if you are not. For example, do not respond with counteroffers right away. Act unconcerned that time is passing. Have a “poker face.” Remember that the bargaining model indicates that the more patient player gets the higher fraction of the amount that is on the table.

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Practical Lessons II How to find out the other player BATNA and level of impatience? Suppose you consider buying a house. Is the house on the market for a long time?  low BATNA for the seller (no one wants to buy). If the owner moving to another city.  low δ, or highly impatient

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Summary Bargaining as sequential games. Use rollback to find the SPE. Split of surplus depends on the number of rounds, and relative patience. BATNAs affect the outcome Better have good outside options Potential for strategic moves to increased your BATNA or perceived patience