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A Guide to Game Theory and Negotiations

2009 NOVEMBER 29
by Greg Satell
tags: Game Theory, John Nash, John von Neumann, Leadership,

Negotiations, Prisoner's Dilemma, Strategy
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Everybody negotiates. Some people like it, others hate it but all agree that the ability to
negotiate well is a valuable business skill and therefore its something worth doing well.
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To be successful in negotiations, you have to be tough, but it also helps to have a strategy.
Fortunately, Game Theory provides us with insights that can lead to practical results.
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The Simplest Game: Two Person with a Fixed Pie

Usually when we think of negotiations, we imagine two people facing off against each other.
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Whatever one wins, the other loses. These were the first type of games that Game
Theory attempted to solve, so its a good place to get started.
Look at the following example where Neil owes Bob some money and they have to agree on
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how much. They each have two strategies available to them, but the outcome is
not just dependent on the strategy chosen, but also on what their opponent
does. So while Neil would obviously choose to pay the minimum (4) and Bob would like to
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have the maximum (6) the opposing move needs to be taken into account before an optimal
strategy can be selected.
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Neil Pays Bob: 2 Strategies
This is about the simplest game imaginable, so you dont have to be a game theorist to figure
out that the payoff will most likely be 5, but it illustrates a very good rule called the minimax
theorem. The concept, which was originated by the legendary John von Neumann, simply
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says that you should pick the strategy where the maximum advantage of your
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opponent is minimized.
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In the above example, Neil would pick strategy #2 to avoid the possibility of having to pay 6
while Bob would pick strategy #1 to avoid only getting paid 4.
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Minimax is a simple but useful rule that can be applied to everyday situations. However, its
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problematic partly because it assumes perfect information. In the real world, things are
much more confusing, not least because our negotiating opponent is rarely limited to two
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strategies.
Lets see what happens if we add additional strategic possibilities.
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Neil Pays Bob: 4 Strategies
Mathematically, the game is still solvable, but you can see that it gets much more
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complicated just by adding a few extra strategic choices. Therefore, it is generally an

advantage to have less options for yourself and more options for your opponent (although a
bit counter-intuitive).
Game theorists achieve this mathematically by determining which strategies are numerically
dominant and using randomly mixed strategies. In real life, you just need to have a clear
idea of what you want and eliminate inferior options. Your advantage can sometimes be
increased if you dont announce your preferences to your opponent so that he still has to
consider variables which you dont.
Reducing variables for yourself is almost always a good idea. Ironically,
someone with a gun to his head is in a very strong negotiating position (with people other
than the gunman of course) because he has few choices . In the world of business, we
usually refer to a boss or shareholders in order to show that our options are limited, but the
principle is the same.
In reality negotiations have many complications. For instance, it makes a big difference if
one player chooses first, whether they play one time or if its an ongoing game, whether
there are side deals, etc.
One particularly interesting real world difficulty that well discuss next is that we often find
that some agreements seem to be in place even before we start negotiating!
Bargaining without Bargaining
When you negotiate internationally, you often hear the phrase everybody knows that it
works this way. This can be very frustrating; not least because it so often follows you saying
thats the craziest thing Ive ever heard!
This phenomenon is a result of tacit bargaining, a term first coined by Thomas Schelling
(he later won the Nobel Prize for his work). Its more common than you would think.
Consider the following experimental results cited by Schelling:
When asked to pick any number, 40% chose the number 1.
The overwhelming majority of people chose heads over tails on a coin toss
When asked to pick any amount of money almost all people chose a figure divisible by 10
When people where told that they had to meet someone else but had to guess the time
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almost all chose noon.

An overwhelming majority of people would rather pay dues than taxes
We often concede to convention without even knowing it (although it becomes much more
apparent when we encounter customs were not used to). It is natural for us to want to
abide by notions of fairness and precedence. Nobody likes to be seen as rocking the boat.
Therefore, it is generally an advantage to make the first move in a
negotiation, even though most people are reticent to do so. Making the first
proposal gives you the opportunity to frame the negotiation and establish
precedence.
Another insight gained from research into tacit bargaining is that often an outsider can be
more effective. Thats why when you start getting comfortable with a car salesman you
inevitably end up in the managers office to close the deal.
Making Commitments: Promises and Threats
Zero sum negotiations are actually quite rare. We usually enter negotiations because we
expect the results to enlarge the total pie and make both sides better off. In effect, we
prevail with a mixture of cooperation and competition andwe will have to
make commitments in the form of promises and threats.
Lets look at some examples. Because these are non zero sum examples, we show payoffs to
both players . In each box, Bob gets the payoff colored in red while Neil gets the payoff
colored in green.
Bob wins by threatening Strategy #2

In the above example, it seems at first that Neil has a much better hand. He can gain from
either of his strategies while only one of Bobs strategies results in a payoff.
However, if Bob threatens to pick strategy #2 if Neil picks #1, he can come out ahead as long
as the threat is credible. Since Neil will lose more than he will, its a very viable course of
action.
In the next example, there is only one scenario where both players can gain. For Bob to gain
something, he has to promise Neil that he wont be greedy.
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Bob must promise Strategy #2

While it might seem that Bobs better strategy is #1, the only way he will be actually able to
gain anything is by promising Neil that he will pick strategy #2. If he doesnt, Neil will pick
his strategy #1 in order to avoid a loss.
In this next example, a promise of a side payment turns a very bad position into a a big
winner. Bob wins by promising a side payment of $2
Bob wins by promising a side payment

By offering the side payment, Neils payoff for choosing his strategy #2 is superior to his
strategy #1. Morover, he can feel confident that Bob will choose strategy #1 because that is
now Bobs dominant strategy. So Neil will gain 3 and Bob will gain 8.
While we all value freedom, in negotiations the commitments we make can be
extremely valuable, if theyre credible. Since they limit our options, it often takes
some effort to get our negotiating partner to believe in us. Contrary to the stereotype, the
last thing a good negotiator wants is to be seen as is slick.
Prisoners Dilemma
The most famous and interesting example in Game Theory is the Prisoners Dilemma.
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Prisoners Dilemma width=300

height=283 />
Prisoners Dilemma
The basic narrative should be familiar to anyone whos watched a cop show. Two suspects
are brought in and interrogated separately.
If they effectively cooperate with each other they will get off on a lesser charge and serve
only two years. If one defects, he will only get one year in prison while his friend gets a
harsh five year sentence. If they both defect, they will each get three years.
(note: There are many variations of the Prisoners Dilemma that use different
values).
While they would both obviously benefit from keeping their mouths shut,
individually the dominant strategy is to talk. By confessing, each will be better off
no matter what the other one does and by holding out each will be worse off.
This is an example of the Nash equilibrium made famous in the movie A Beautiful Mind and
shows how sometimes a stable solution can also be a bad one. In effect, everybody can
agree to be worse off.
Three quick points about the Prisoners Dilemma before we move on:
Trust: Building credibility is essential to avoiding defection
Tit for Tat: Experimentally, the most successful solution has been shown to
be Tit for Tat first formulated by Anatol Rapoport, where you reciprocate
your opponents last move. Cooperation brings cooperation and defection
brings defection.
Continuity: If the prisoners dilemma is open ended, people have more
reason to cooperate. However, if the engagement is limited they will be
more likely to defect. The reason why is called a backward induction
paradox. If there are 100 games, then it makes sense to cheat on the last
one. But if each player knows that, it makes sense for him to get ahead by
cheating on the 99th. The same logic would hold for the 98th and so on all
the way back to the first game.
Bigger Games
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Of course, many games involve more than two people and most negotiations
take place in a larger context. A salary negotiation will ultimately affect other
salaries in the same company, a price negotiation will have ripple effects for an
industry, etc.
Games with more than two people are called N-person games. Understandably,
they are much more complex than two person games and we cant do them
justice here. However, I think its worth it to go over a few basic points:
All N-person games are defined as zero sum.
Most solutions are based on voting models and coalition building.
Your power is derived from the probability of casting the 51st vote out of
100.
Size isnt always an advantage. In a company that has a share structure of
40-40-20, all shareholders would have equal power. If the two bigger
players are antagonists, the smallest player can actually run the show!
Practical Applications for Real World Negotiations
While its important to remember that Game Theory consists of sanitized models with often
unrealistic assumptions, we can derive some useful principles that can improve results in
real world negotiations:
Minimize Risk: As the minimax theorum shows, all things being equal it is
usually a good strategy to minimize your opponents maximum payout, even
if that means that you are guaranteeing him a higher minimum.
Make the first offer: Unless you are at a demonstrable informational
disadvantage, it is better to go first. This allows you to frame the
negotiation to your advantage. Although its against most peoples natural
inclination, the evidence is pretty strong here.
Beware of Precedence: While its difficult to go against convention, there is
no reason to simply accept a situation where you are at a disadvantage.
Trust: The ability to make commitments such as promises and threats can
be extremely valuable. If you lack credibility, you lose that capacity.
Sometimes its better to incur a cost rather than lose stature.
Continuity: Open ended commitments encourage reliability while short
term relationships abet duplicity. Thats why all tourists are suckers.
Reciprocity: Rapoports Tit for Tat strategy and subsequent evidence
shows that you can expect to get what you give. Moreover, while there is no
reason to set out on a nasty path, sometimes thats where youll have to end
up. As the Al Capone character in The Untouchables said You get more
with a kind wordand a gun, than you do with just a kind word.
I hope this has been helpful. Please let me know your comments.
Greg
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16 Responses
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Chris Cozea
PERMALINK
November 30, 2009
Says Dr. Lawrence Cohen:

Wherever complex cooperation has been able to evolve, it is
because cooperators have been able to capture the effects on
others of their actions. As a result, self-interest has driven
them to treat the other as self. A strong example that may not
be immediately obvious is an economic market. The market
will reward an individual who develops a new product that
benefits others by satisfying their needs better than existing
products. Selling the product enables the individual to capture
the beneficial effects that the product has on others. In the
limited areas where economic markets work effectively,
individuals benefit in this way from actions that benefit
others. Where the market enables individuals to capture the
benefits of their effects on others, the market aligns the
interests of individuals with the interests of others.
In contrast, where the barrier to the evolution of cooperation
has not yet been overcome, cooperators do not capture the
beneficial effects on others of their actions. For example, in
our economic system, a person will not capture the benefits of
providing food to people who are starving in an African
famine. It would be far more profitable to invent an improved
mousetrap. Or a new weapon of mass destruction. But when
the barriers to cooperation in human society are overcome,
and when all individuals capture in full their beneficial effects
on others, the provision of food to the starving will be a
lucrative way to make a living.
[Reply]
Chris Cozea
PERMALINK
November 30, 2009
Cosmides:
The game theoretic models for the evolution of cooperation
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that could be reasonably applied require the existence of

some mechanism for detecting cheaters or otherwise
excluding them from the benefits of cooperation. This is
because the capacity to engage in social exchange could not
have evolved in the first place unless the individuals involved
could avoid being continually exploited by cheaters. But most
models do not require the existence of a mechanism for
detecting altruists individuals who follow the strategy of
paying the required cost (thereby benefiting the other party),
but not accepting from the other party the benefit to which
this act entitles them. Indeed because individuals who were
consistently altruistic would incur costs but receive no
compensating benefits, under most plausible scenarios they
would be selected out. From the perspective of deontic
thinking, we would expect no difference in facilitation.
[Reply]
Steve Yousten
PERMALINK
December 2, 2009
Hi Greg.
Another good article. Game theory is fascinating stuff, but just
understanding it can be challenging sometimes. You were able
to present the concepts in a relatively easy to understand way.
[Reply]
Greg Reply:
December 3rd, 2009 at 12:46 am
Steve,
Thanks. Thats very kind of you.
Greg
[Reply]
Joan
PERMALINK
December 19, 2009
Hi Greg,
I was interested in your article but could not follow it in terms
of real-life conversations people can have with their bosses. I
would like to hear negotiating tips and what has worked for
you in the past. The game theory is not personal and I like
personal.
[Reply]
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Greg Reply:
December 19th, 2009 at 9:07 am
Joan,
Well, if I could boil it down to one point (which I cant) I
would say that the one thing to get right is credibility. Most os
negotiation tactics will only be effective if the other side
believes us.
I hope that helps.
Have a nice holiday.
Greg
[Reply]
Paul
PERMALINK
December 23, 2009
Hi Greg,
Another lucid and thought provoking item. Im about to
embark on a complicated negotiating process with a possible
partner although we have previously been competitors. This
has helped me simplify and clarify my approach.
many thanks
Paul
[Reply]
Greg Reply:
December 23rd, 2009 at 6:15 pm
Paul,
Thanks. Im glad it was helpful.
Happy Holidays!
Greg
[Reply]
Peter
PERMALINK
March 13, 2010
Greg,
Good article. I have always wondered about practical use of
Game Theory.
However, some Case Studies may help.
regards,
Peter
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[Reply]
aron kenyon
PERMALINK
June 21, 2011
Gregg is was very helpful as i copy and pasted it for a piece if

work
[Reply]
Greg Reply:
June 21st, 2011 at 9:42 pm
Glad to hear it!

Greg
[Reply]
Joseph
PERMALINK
August 30, 2012
I am working on developing a video game for people to

practice salary negotiations. Id love you input!
http://www.salarynegotiators.com/become-an-expert-salarynegotiator-video-game-style/
[Reply]
Greg Reply:
August 30th, 2012 at 6:04 pm
Sure. Let me know what I can do. Youll find my LinkedIn

profile on the about page.
Greg
[Reply]
Moe
PERMALINK
December 7, 2012
good article!
Tit-for-tat is a good strategy in a repeated version of prisoners
dilemma.
[Reply]
Greg Reply:
December 7th, 2012 at 12:12 pm
Yes, it is!
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Greg
[Reply]
Melissa
PERMALINK
August 11, 2013
Great article about the art of negotiation. To negotiate or not

to negotiate that is the question.
Love the game theory.
[Reply]
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Home About Greg Satell Hire Greg Mapping Innovation

A Guide to Game Theory and Negotiations

tags: Game Theory, John Nash, John von Neumann, Leadership,

The Simplest Game: Two Person with a Fixed Pie

* = requ ired field

The 2016 Digital Tonto Reading

What A President Trump Could